Finance 640

Financial Management and Policy

Lecture Notes
Session 6

Introduction

Up to this point in the class we have progressed through several important steps in
corporate financial analysis. We began with an understanding of financial statements and
methods of evaluating standing and performance with the use of financial ratios. We then
learned how to forecast financial performance using financial statements and ratios to
develop an understanding of how companies might perform in the future. Next, we
turned our attention to present value and methods of pricing stocks and bonds. Stocks
and bonds are the means by which companies raise money, as well as the market’s way of
assigning value to a company once it begins its operations. In our last unit, we examined
how those stock and bond pricing models can be used to determine the cost of capital for
a company. The cost of capital is an important measure because it represents the return
required by investors prior to their allowing a company to use their money. It becomes
the cost of using that money to the corporation.

In this unit, we begin to put these concepts together to determine the market value
of a corporation. The process will begin with financial statements and end with a net
present valuation using the weighted average cost of capital (WACC) as a discount factor.

Theory of Valuation

The main source of value of a corporation is the income it can provide its
investors. One way in which we have measured income is using the net income on the
income statement. While this is a great measure of the economic performance of a
company, it is not necessarily a good measure for determining value to investors. The
reason is that net income does not necessarily translate into available cash flow for
investors.

Investors in a corporation include bondholders and other creditors (such as

banks), and both preferred and common equity owners. Creditors are not paid out of the
net income of the company, but rather, out of the free operating cash flows generated by
the company in the pursuit of its business. A free cash flow is an amount of dollars that
are available for distribution to investors. This distribution can take the form of interest
and/or principle payments to creditors, dividends paid to shareholders, or funds used to
repurchase shares from stockholders. A firm may not have a positive net income, but
may have positive free cash flow. Likewise, it may have positive net income, but a
negative free cash flow. You will see why as you read on.

In finance, value is generally determined by discounting net cash flows. In the

case of determining corporate value, we first identify the free cash flows and then we
discount them using an appropriate cost of capital. If we are trying to value the firm as a
whole (as opposed to valuing the debt or equity separately), we will use the WACC as the
discount factor. More will be said about the implicit assumptions and limitations of this
use later on.

Free Cash Flows

Free cash flows represent cash available for investors after all of the needs of
operating the business including its ability to operate in the future are met. The starting
point for calculating free cash flow is the net operating income after tax (the book uses
the term NOPAT, or net operating profit after tax—generally speaking, income and profit
are the same). The net operating income typically includes all revenues and expenses that
relate to the day-to-day operation of the business. It does not include interest expenses or
any other financial cash flow. It is important to note that the differentiation here is
between operating and financial cash flows.

Operating revenues are earned and operating expenses incurred as a direct result
of applying corporate resources to do business. Financial cash flows, on the other hand,
relate to decisions the company has made regarding how it raises its capital. For
example, interest and principle payments are financial cash flows. These need to be paid
out of the operating cash flows. The company’s ability to make these payments is an
important factor in determining its value. Since the payments are made out of the free
cash flows, the amounts are not deducted from the free cash flows in determining value.

In addition to the NOIAT, there are two other elements to the calculation of the
free cash flow. First is the new investment in net working capital required to sustain
business operations. As you know, net working capital is the difference between current
assets and current liabilities. When measuring current liabilities, however, it is important
to include only those that result from day-to-day operations. This would not include any
interest bearing liabilities such as notes payable. Notes payable relate to financial and not
operating cash flows. The impact of these will be picked up in the WACC.

The new investment in net working capital is measured by the change in the level
of net working capital required to sustain operations from year-to-year. For example, if
the current year’s net working capital level is $469MM, and next year’s required level is
$522MM, the new investment in net working capital is the difference between the two, or
$53MM.

The second element included in the determination of free cash flow is the net
investment in plant, property and equipment (fixed assets) needed to sustain the business
operation. This amount includes the increase (or decrease) in gross fixed assets (that is,
before accumulated depreciation) less the depreciation expense for that year. Subtracting
the depreciation expense is the same as adding it back to the free cash flow. This is
important because depreciation is a non-cash flow expense that is deducted from the net
operating income before taxes are calculated. Since it is available cash, however, it
should be included in the free cash flow calculation.
 In order to determine the free cash flow for a year, it is necessary to have the
income statement for the year and the balance sheets from both the beginning and end of
the year. The first step is to identify the net operating income after tax (NOIAT or
NOPAT) and then adjust for operating net working capital and net new fixed investments.
An example is included in a spreadsheet named freecashflow.xls.

From the example you can see several important points. First, dividend payments
are not included in the calculation. Dividend payments are residual financial cash flows
and are not part of the operating free cash flow. Next, note that the notes payable are not
included in the calculation for the same reason. The example shows an operating free
cash flow made up of the following:

Free Cash Flow Calculation for 2003E 2002 2003E

EBIT $9,471
Taxes at 40% ($3,788)
NOIAT (NOPAT) $5,683

Change in Operating Net Working Capital

Operating Current Assets (Total Current) $5,610 $6,292
Change in Operating Current Assets (2003E-2002) $682
Operating Current Liabilities (A/P and accruals) $2,652 $3,105
Change in Operating Current Liabilities (2003E-2002) $453

Increase (decrease) in Operating Net Working Capital $229

Change in Fixed Assets

Gross Fixed Assets $13,200 $15,700

Change in Gross Fixed Assets (2003E-2002) $2,500

Less depreciation expense (2003E) ($1,320)
Net new investment $1,180

Free Cash Flow for 2003E

NOIAT (NOPAT) $5,683

(Increase) decrease in Operating Net Working Capital ($229)
(Increase) decrease in Net new investment ($1,180)
Operating Free Cash Flow $4,273

Discounting to Determine Value

As mentioned earlier, determining value involves discounting a string of net cash

flows. In this application, the net cash flows are the operating free cash flows as
measured above. To complete the process of cash flow estimation, we would generate a
set of pro forma financial statement forecasts forward for about five to ten years. The
calculation of operating free cash flows would be replicated for each of those five to ten
years as above. Once this step has been completed, it is necessary to estimate the value
of any cash flow earned by the company beyond the end of the five to ten year forecast
period. The present value of these cash flows constitutes what is referred to as the
horizon or continuation value of the company. Calculating this value is important
because we assume that a company is a going concern with a theoretically unlimited life
as an entity. To determine this horizon value, we can take advantage of the “constant
growth” stock valuation model we learned in Session 4.

Suppose we have a five-year financial forecast, and that the operating cash flow
for the fifth year is $5,398MM. To calculate the horizon value we first need to make an
assumption about the rate of growth in the cash flows beyond year five. Here, it is
always safe to be conservative, so we will use four percent (4%). Assuming that we
know the discount factor (as will be seen, it is the WACC) is 12.83%, the horizon value
would be calculated as follows:

HV5 = OFCF5(1+g)/(WACC – g) = $5,398(1.04)/(.1283-.04) = $5,614/(.0883) = $63,546MM.

The $63,546 will become a net cash flow measured at the end of period five. Imagine it
as the price at which the firm will sell at that time. If you were investing in the firm
today, the $63,546MM would be the value you’d expect to receive when you sell the
company in five years. Regardless of whether the company is sold, however, it is still
worth that much at the time.

The Discount Factor

The discount factor used to discount the operating free cash flows is the weighted-
average cost of capital. As you learned in Session 5, the WACC accounts for the different
types of debt and equity in the capital structure of the company. The weights are
determined by the amount of capital raised by each unit. These amounts are usually
obtained from the balance sheet, and therefore represent historical book values. The
freecashflow.xls spreadsheet has a sample calculation of the WACC, assuming that you
already know the values of the individual component costs of capital (e.g. such as the
cost of equity that results from the CAPM). The component costs here are assumed (made
up), so don’t worry about where they came from. The amounts come from the 2002
balance sheet.

Weighted Average Cost of Capital

Calculation
Type of Capital Amount Weight Component Tax (2)*(3)*(4)
Cost Adjustment
Note Payable $950 6.40% 9.20% 0.60 0.35%
Long Term Debt $1,200 8.09% 10.50% 0.60 0.51%
Common Equity $12,688 85.51% 14.00% 1.00 11.97%
Total Capital $14,838 100.00% WACC= 12.83%

There are two critical assumptions we implicitly make by using the WACC as a
discount factor. First, we assume that the component costs of capital are going to be the
same over the entire forecast horizon (which is infinite in this case!). Second, We assume
that the relative weights of each source of capital (note payable, long-term debt and
common equity) will remain the same over the forecast horizon. While these are
somewhat restrictive, we will make do for now and show what happens when things are
allowed to change at a later time.

Discounting to Determine Value

Once we have completed the calculation of the operating free cash flows for the
forecast period (in this case, five years), the horizon value, and the WACC, we are ready
to measure market value. To do this we simply discount the net cash flows as follows:

Corporate Valuation Using Free Cash

Flows and WACC

Year 2002 2003E 2004E 2005E 2006E 2007E

Operating Free Cash Flow $4,273 $4,658 $4,987 $5,123 $5,398
Horizon Value $63,546
Total Free Cash Flow $4,273 $4,658 $4,987 $5,123 $68,944
WACC 12.83%
Present (Market) Value @ WACC $51,774

Book Value of Note Payable $950

Book Value of Long Term Debt $1,200
Book Value of Common Stock $12,688
Total Book Value of Capital $14,838

Market Value Added (Market - Book) $36,936

Note that the horizon value is included as a cash flow to be discounted in year five
(2007E). The present value of the total free cash flows discounted at 12.83% is
$51,774MM as of 2002. This is the market value of the company (this can also be
referred to as the market value of the assets, as this company has no non-operating
assets).

The market value added by managing the assets is $36,936. It is obtained by

subtracting the book value of the capital from the market value of the assets, as can be
seen above.

What you should do now is go through the textbook reading for this session
(Chapter 12) and reconcile what you find there to the material in this presentation. A
discussion problem will be posted to give you practice in making this calculation.