Professional Documents
Culture Documents
class #3
payables NWCR
$
payment
Operating Assets
Financial Liabilities
(Receivables + Inventories + Accruals)
(Bank Loans, Bonds, etc)
Fixed Assets
Shareholders’ Equity
Fixed Assets
Shareholders’ Equity
Net Debt
Future Cash Flows Capital Cost of debt (RD)
Employed RWACC
Operating Income (FA+NWCR) Equity Cost of Equity (RE)
• EV is thus the present value of the future operating cash flows generated by the firm’s operating
assets (FA+NWCR) discounted at the appropriate wacc; this is why EV = Net Debt + Equity
• Annually, the firm’s operating income (after taxes) must be sufficient to pay for the cost of funding
the company’s operating assets
• Value is only generated, on a yearly basis, if the return generated by these assets is higther than the
cost of funding them
• In order to continuously being adding value, companies must generated a ROCE that
exceeds their cost of capital:
• ROCE > RWACC
• The annual contribution to value creation is designated EVA (Economic Value
Added), which is measured as follows:
• EVA = Operating Profit Net of Taxes* – Capital Employed × RWACC
(*) Frequently designated as NOPLAT (net operating profits less adjusted taxes)
10
So, is it future cash flow growth that drives value?
• Let us make this company perpetually grow at 2% per year
• The return on invested capital is 14% (11.2% after-tax)
• The cost of capital for investors is 8%; tax rate is 20%
Year: 1 2 3 4 5 Perpt
Invested Capital 1000.0 1020.0 1040.4 1061.2 1082.4 2% growth
EBIT 140.0 142.8 145.7 148.6 151.5
Taxes on EBIT 28.0 28.6 29.1 29.7 30.3
NOPLAT 112.0 114.2 116.5 118.9 121.2
Investment 20.0 20.4 20.8 21.2 21.6
Cash Flow 92.0 93.8 95.7 97.6 99.6 1692.9
Present Value: 1533.3
99.6×1.02
0.08-0.02
• The value of this firm is now 1533, which is 133 higher than with no growth
• Growth seems to have added value to the firm, but it is not the main driver of value creation of this
firm (400 still to explain)
11
Value of the firm, capital employed and wacc
• The value of the previous example firm may be expressed as:
112 − 20 𝐼𝐶 × 𝑅𝑂𝐶𝐸 − 𝑔 × 𝐶𝐸
𝑉 = =
0.08 − 0.02 𝑟−𝑔
𝐼𝐶 × 𝑅𝑂𝐶𝐸 − 𝐶𝐸 × 𝑔 𝑅𝑂𝐶𝐸 − 𝑔
𝑉 > 𝐶𝐸 ⇒ > 𝐼𝐶 ⇒ > 1 ⇒ 𝑅𝑂𝐶𝐸 > 𝑟
𝑟−𝑔 𝑟−𝑔
• Thus, the condition for value creation is not growth but rather the company’s ability
to generate a ROCE that exceeds its cost of capital
12
The relationship between value and growth
EV Company's growth rate
1533,3 0% 1% 2% 3% 4% 5% 6%
4% 500,0 428,6 333,3 200,0 0,0 -333,3 -1000,0
Growth
Company's after-tax Return on Invested Capital
13
How much (net) Working Capital is needed?
Fixed Assets
Shareholders’ Equity
Long-Term Funding
Working capital is the amount of current assets that is financed by long-term funds and
works as a financing safety net against fluctuations of NWCR and difficulties with short
term funding
Paulo Soares de Pinho Applied Corporate Finance 14
Seasonal Company – Conservative Approach
Surplus
Capital Employed
Surplus
Surplus
(FA+NWCR)
Fixed Assets
time
Company employs too high volume of long term funds
Most of the time uses very expensive funds (LT debt + equity) to fund short term treasury applications
(deposits, securities) => negative margin
Extremely low (re)financing risk
A B
Capital Employed
ST Debt
ST Debt
(FA+NWCR)
ST Debt
D Long Term Funding
Net Working Capital
Fixed Assets
time
Company uses long term funding to finance permanent needs (only)
All seasonal NWCR are funded by short term debt; Permanently dependent upon renewal of short
term funding requirements
Moderate financing risk
C D
Capital Employed
(FA+NWCR)
ST Debt
ST Debt
ST Debt
F
Fixed Assets
Negative Net Working Capital
time
Company with insufficient long term funds to support permanent capital requirements, leading to
negative net working capital; Excessively reliant on short-term funding
High refinancing risk
E F
Long Term Long Term
Fixed Assets Funding Fixed Assets Funding
Short Term
Funding
Short Term NWCR
NWCR Funding
ST Debt
ST Debt
Capital Employed
(FA+NWCR)
Surplus
Surplus
Net Working Capital
H Fixed Assets
time
Company sets us working capital to alternate periods on negative and positive treasury. At the
bottom of the NWCR cycle, long term-funding is excessive for NWCR needs and the company has
zero ST bank borrowings. At the top of the NWCR cycle the company partially finances temporary
NWCR with ST debt
Paulo Soares de Pinho Applied Corporate Finance 21
Equilibrium
G H
With this policy the company agrees with its banks to use flexible short term bank borrowings
such as credit lines that allow it to borrow up to a certain maximum amount, to withdraw money
or repay debt as needed, paying interest only on the outstanding balance plus a fee.
ST Debt
ST Debt
Surplus
time
Maintaining the original financial policy requires the firm to make long term funds to grow in line with the
capital employed in fixed assets and NWCR
That may imply dividend limitations, raising new long term loans and even new equity (in order to keep
the ability to raise new debt and maintain overall financing risk)
ST Debt
ST Debt Negative Net Working Capital
Working Capital
surplus
time
If long term funds do not accompany the evolution of long-term capital employed, then working capital declines
by the time until becoming negative. The company’s financial ratios deteriorate (leverage and liquidity) making
it more difficult and expensive to raise new short term debt. One day, the company’s ability to borrow stops and
a liquidity crisis may become inevitable.
Dell’s COGS
Current Liabilities:
Accounts Payable 466 403 NA
Accrued and Other Liabilities 473 349 NA
Total Current Liabilities 939 752 538
Long Term Debt 113 113 100
Other Liabilities 123 77 31
Total Liabilities 1 175 942 669
Stockholders’ Equity:
Preferred Stocka 6 120 NA
a
Common Stock 430 242 NA
Retained Earnings 570 311 NA
Other (33) (21) NA
Total Stockholders’ Equity 973 652 471
2 148 1 594 1 140
(C) = (A) - (B) Total Net Workig Capital Requirements 372 191 173
Net Treasury
Cash 55 43 3
Short Term Investments 591 484 334
(E) Total Net Treasury -646 -527 -337
(H) = (F) + (G) Total Long Term Funds 1 209 842 602
(C) = (A) - (B) Total Net Workig Capital Requirements 534 219 276
Difference: 162 28
ROCE 42.3%
(C) = (A) - (B) Total Net Workig Capital Requirements 558 372 7.0%