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Chapter 3

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

Cal State East Bay

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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
Cal State East Bay

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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• AR and inventory increased. Cal State East Bay 6 . • Cash and short-term investments fell.Effect of Expansion on Assets • Net fixed assets increased.

earnings. earnings. 2007 Less: Dividends paid.5 (57.5) 766 7 .Statement of Retained Earnings. 2007 Balance of ret. 12/31/2007 Cal State East Bay 710 113. 12/31/2006 Add: Net income. 2007 Balance of ret.

000 8 .680 766 896 2.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 Cal State East Bay 710 840 1.

What effect did the expansion have on liabilities & equity? • CL increased as creditors and suppliers “financed” part of the expansion. • The company didn’t issue any stock. • Long-term debt increased to help finance the expansion. Cal State East Bay 9 .

5) 10 .) Adjustments: Depreciation Change in AR Change in inventories Change in AP Change in accruals Net cash provided by ops.Statement of Cash Flows: 2007 Operating Activities Net Income (before preferred div. Cal State East Bay 117.5 100 (60) (200) 30 10 (2.

(230) 65 (165) Cal State East Bay 11 . act.Investing Activities Cash used to acquire FA Sale of Short term investments Net cash provided by inv.

5) 162. act.Financing Activities Change in notes payable Change in long-term debt Payment of cash dividends Net cash provided by fin. 50 174 (61.5 Cal State East Bay 12 .

Net change in cash Cash at beginning of year Cash at end of year Cal State East Bay (2.5 (5) 15 10 13 .Summary of Statement of CF Net cash provided by ops. Net cash to acquire FA Net cash provided by fin.5) (165) 162. act.

What can you conclude from the statement of cash flows? • Net CF from operations = -$2. because of increases in working capital. • The firm borrowed and sold some short-term investments to meet its cash requirements. the cash account fell by $5.5. • The firm spent $165 on FA. Cal State East Bay 14 . • Even after borrowing.

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 company’s value depends upon the amount of FCF it can generate. Cal State East Bay 15 .

•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 )  Cal State East Bay 3 .•Basic Corporate Valuation Model •Sales Revenues •Operating Costs and Taxes •Required Investments in Ops.16 .

5.g.) Cal State East Bay 17 . Buy nonoperating assets (e. 3. Pay interest on debt. marketable securities. Pay back principal on debt..What are the five uses of FCF? 1. Pay dividends. etc. 2. 4. investments in other companies. Buy back stock.

– Op CA exclude: short-term investments.What are operating current assets? • Operating current assets are the CA needed to support operations. Cal State East Bay 18 . because these are not a part of operations. – Op CA include: cash. inventory. receivables.

Cal State East Bay 19 . – Op CL exclude: notes payable. – Op CL include: accounts payable and accruals. not a part of operations. because this is a source of financing.What are operating current liabilities? • Operating current liabilities are the CL resulting as a normal part of operations.

($60 + $140) = $800. NOWC06 = $585.What effect did the expansion have on net operating working capital (NOWC)? Operating Operating NOWC = CA CL NOWC07 = ($10 + $375 + $615) . Cal State East Bay 20 .

What effect did the expansion have on total net operating capital (also just called operating capital)? • Operating Capital= NOWC + Net fixed assets.455.800. • Operating Capital 2006 = 870 + 585= $1.000 = $1. Cal State East Bay 21 . • Operating Capital 2007 = $800 + $1.

8(1 .4) = $170.Did the expansion create additional net operating profit after taxes (NOPAT)? NOPAT = EBIT(1 .8.0.3. Cal State East Bay 22 .Tax rate) NOPAT07 = $283. NOPAT06 = $157.

800 .What was the free cash flow (FCF) for 2007? FCF = NOPAT .$1.3 .$345 = -$174.3 .Net investment in operating capital = $170.7.($1.455) = $170. Cal State East Bay 23 .

800 = 9.Return on Invested Capital (ROIC) ROIC = NOPAT / operating capital ROIC07 = $170.3/ $1. Cal State East Bay 24 .46%.

Cal State East Bay 25 . negative FCF. Did the growth add value? • No.The firm’s cost of capital is 10%. The ROIC of 9. • Note: High growth usually causes negative FCF (due to investment in capital). Investors did not get the return they require. Home Depot had high growth. For example. but that’s ok if ROIC > WACC. but a high ROIC.46% is less than the WACC of 10%.

(WACC)(Capital) Cal State East Bay 26 .Economic Value Added (EVA) • WACC is weighted average cost of capital • EVA = NOPAT.

5 = $12.(0.3.7.3 Cal State East Bay 27 .10)($1.3.455) = $157.(0.800) = $170.8 .Economic Value Added (WACC = 10% for both years) EVA = NOPAT.$145.8 . EVA06 = $157.$188 = -$17.(WACC)(Capital) EVA07 = $170.10)($1.

Stock Price and Other Data 2006 Stock price $26 2007 $23 # of shares 50 50 Cal State East Bay 28 .

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…) Cal State East Bay 29 .Market Value Added (MVA) • MVA = Market Value of the Firm .

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 Cal State East Bay 30 .

• Book Value of Equity 2007: – $896. • MVA07 = $1.2007 MVA (Assume market value of debt = book value of debt. Cal State East Bay 31 . • MVA06 = $1.150.$840 = $460.$896 = $254.300 .00) = $1.150 .) • Market Value of Equity 2007: – (50)($23.

CHAPTER 12 •Cash Flow Estimation and Risk Analysis Cal State East Bay 32 .

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 Cal State East Bay 33 .

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 Cal State East Bay 34 .

Estimating cash flows: – Relevant cash flows – Working capital treatment – Inflation Cal State East Bay 35 .

000. Cal State East Bay 36 .000 cost + $10. • Salvage value = $25. • Economic life = 4 years.000 shipping + $30. • MACRS 3-year class.000 installation.Proposed Project • $200.

Unit sales price = $200.• • • • Annual unit sales = 1. Net operating working capital (NOWC) = 12% of sales. • Project cost of capital = 10%.250. Cal State East Bay 37 . Unit costs = $100. • Tax rate = 40%.

Incremental Cash Flow for a Project • Project’s incremental cash flow is: Corporate cash flow with the project Minus Corporate cash flow without the project. Cal State East Bay 38 .

If we subtracted them from cash flows. • They are part of the costs of capital. and so we should discount the total amount of cash flow available to all investors. 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). Cal State East Bay 39 .Treatment of Financing Costs • Should you subtract interest expense or dividends when calculating CF? • NO. we would be double counting capital costs.

Sunk Costs • Suppose $100. Cal State East Bay 40 .000 had been spent last year to improve the production line site. Should this cost be included in the analysis? • NO. Focus on incremental investment and operating cash flows. This is a sunk cost.

• A.000 a year. opportunity cost = $25.000 annual cost.Incremental Costs • Suppose the plant space could be leased out for $25.T.000 (1 .000. Cal State East Bay 41 . Would this affect the analysis? • Yes. Accepting the project means we will not receive the $25. This is an opportunity cost and it should be charged to the project.T) = $15.

Cal State East Bay 42 . • Externalities will be positive if new projects are complements to existing assets. negative if substitutes. • Net CF loss per year on other lines would be a cost to this project.Externalities • If the new product line would decrease sales of the firm’s other products by $50. would this affect the analysis? • Yes.000 per year. The effects on the other projects’ CFs are “externalities”.

000 Cal State East Bay 43 .What is the depreciation basis? Basis = Cost + Shipping + Installation $240.

45 0.Annual Depreciation Expense (000s) Year 1 2 3 4 Cal State East Bay % X 0.0 36.15 0. $79.07 (Initial Basis) $240 = Depr.2 108.8 44 .0 16.33 0.

Annual Sales and Costs Year 1 Units Unit Price Unit Cost Sales Costs Cal State East Bay Year 2 1250 $206 $103 Year 3 1250 $212.18 $106.000 $257.225 $273.750 $132.500 $265.188 $128.000 $125.09 Year 4 1250 $218.588 45 .27 1250 $200 $100 $250.613 $136.55 $109.

then your NPV estimate is lower than what it should be. r. • Nominal CF > real CF. • Use nominal cash flows and use nominal discount rate.• Nominal r > real r. includes a premium for inflation. •Continued… Cal State East Bay 46 Why is it important to include inflation when estimating cash flows? . • If you discount real CF with the higher nominal r. This is because nominal cash flows incorporate inflation. The cost of capital.

000 $125. Net Op.300 $12. CF Cal State East Bay Year 1 $250.200 $45.200 $106.750 $8.450 $108.000 $120.000 $20.450 47 . EBIT Taxes (40%) NOPAT + Depr.320 $27.Operating Cash Flows (Years 1 and 2) Sales Costs Depr.680 Year 2 $257.480 $79.800 $18.000 $79.500 $128.750 $108.

613 $36.000 $93.645 $57.188 $136.967 Year 4 $273.225 $132. Net Op.680 48 .967 $36.920 $71.800 $88.612 $38. CF Cal State East Bay Year 3 $265.000 $96.588 $16.800 $119.800 $47.880 $16.Operating Cash Flows (Years 3 and 4) Sales Costs Depr. EBIT Taxes (40%) NOPAT + Depr.

188 -$30.225 $273.783 49 Cal State East Bay .000 -$900 -$927 -$956 $32.Cash Flows due to Investments in Net Operating Working Capital (NOWC) NOWC (% of sales) $30.000 $30.500 $265.900 $31.000 $257.827 $32.783 $0 CF Due to Investment in NOWC Sales Year Year Year Year Year 0 1 2 3 4 $250.

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 Cal State East Bay 50 .

Accum. • Cash flow from sale = Sale proceedstaxes paid. • Taxes are based on difference between sales price and tax basis.What if you terminate a project before the asset is fully depreciated? • Basis = Original basis . Cal State East Bay 51 . deprec.

72.2) = $3.2.28. Cash flow = $25 . Gain or loss = $25 . Tax on sale = 0.$16. Sales price = $25. After 3 years.$3.8 = $8. Cal State East Bay 52 .8 remaining.4($8. basis = $16.Example: If Sold After 3 Years for $25 ($ thousands) • • • • • • Original basis = $240.28 = $21.

so cash flow is larger than sales price! Cal State East Bay 53 .72. Sales price = $10.$16.72. Cash flow = $10 – (-$2. Gain or loss = $10 .4(-$6.8. Tax on sale = 0.8) = -$2. Sale at a loss provides tax credit.Example: If Sold After 3 Years for $10 ($ thousands) • • • • • • • Original basis = $240.8 = -$6. basis = $16.72) = $12. After 3 years.8 remaining.

Cost Op.780 0 $119.000 0 $105.000 0 -$30.680 -$900 2 0 $120.523 Cal State East Bay 54 .Net Cash Flows for Years 1-3 Init.450 -$927 Salvage CF Net CF 0 -$270. CF NOWC CF 0 -$240.000 1 0 $106.

Net Cash Flows for Years 4-5 3 Init.967 -$956 0 $93.463 55 0 $93.783 $15.680 $32. Cost Op.011 .000 $136. CF NOWC CF Salvage CF Net CF Cal State East Bay 4 0 $88.

523 •3 •93.011 •4 •136. • NPV = $88. • IRR = 23. Cal State East Bay 56 .000) •105.030.Project Net CFs on a Time Line •0 •1 •2 •119.780 •Enter CFs in CFLO register and I = 10.9%.463 •(270.