Determinants of a Firm’s Value
Sales
Operating
Revenues Cost &
Required
Investment
Taxes
Financing
Decisions
+
1
(1 + WACC)
Firm Market
Risk
Risk
in Operations
Weighted Average
Cost of Capital
(WACC)
Free Cash Flows
(FCF)
Value = FCF1
Interest
Rates
FCF2
+
2
(1+WACC)
FCF3 + ……..+ FCF
3
(1 + WACC)
Prepared by Waseem Ahmad
(1+WACC )
Financial Statements, Cash Flow and Taxes
 Management`s Primary Goal is to maximize the value of
Company`s Stock
 Value depends upon the ability of the Company to generate
stream of cash flows in the future.
 Investor estimate future Cash Flow`s of Company by studying
its annual report.
 Annual report contains both Descriptive and Financial
Information about the Company.
 Descriptive section contains CEO report, Auditor report,Future
plans, information about Company`s products etc.
 Financial Portion contains FOUR basic Financial Statements
ie., Balance Sheet, Income Statement, Cash Flow and
Statement of retained earnings Plus last 10years key
Financial results.
Prepared by Waseem Ahmad
 Financial Statements report what has actually
happened to Assets, earnings, and dividends over
the past year/s. Whereas, verbal statements
explain why the things turned out the way they did.
 The information contained in the Annual report is
used by the investors to form expectations about
the future earnings and dividends.
Prepared by Waseem Ahmad
Balance Sheet
 A Traditional Balance Sheet tells us the
Financial position of a Company on a
particular point in time.
 Balance sheet equation is
Assets = Liabilities + Owner`s Equity.
Prepared by Waseem Ahmad
M/s Micro Drive
Balance Sheet ($ in Mil)
31 December 2003 / 2004
Assets
2004
Cash &Eqvlts
10
Shrt Term Invst 0
Accounts Rcvbl 375
Inventories
615
Ttl C/Assets 1000
Net Plant&Eqpt 1000
2003
15
65
315
415
810
870
Total Assets
1680
2000
Liab&Equty
2004
A/c Pybl
60
Note / Payable 110
Accruals
140
Ttl C/Liablities
310
L.Term Bonds
754
Total Debt
1064
P.Stock(400000) 40
C.Stock(50000000) 130
Retained Earnings 766
Total Com Eqty
896
2003
30
60
130
220
580
800
40
130
710
840
Ttl Liab & Eqty
1680
Prepared by Waseem Ahmad
2000
Micro Drive Inc
Income Statement
for the Year ending 31 Dec 03/04
(In Millions)
2004
3000
Operating Cost Excldg Dep/Amtzn
2616.2
Erng b4 Int,Tax,Dpcn&Amtzn(EBITDA)
383.8
Depreciation
100
Amortization
0
Depreciation &Amortization
100
Earning before Int&Tax (EBIT or Op Incm) 283.8
less interest
88
Earning before Tax (EBT)
195.8
Taxes @ 40 %
78.3
Net Income before Preferred dividend
117.5
Preferred Dividend
4
Net Income
113.5
Common Dividend
57.5
Additions to retained earnings
56
Net Sales
Prepared by Waseem Ahmad
2003
2850
2497
353
90
0
90
263
60
203
81.2
121.8
4
117.8
53
64.8
Per Share Data 2004
2003
Common Stock Price
Earning per share (EPS)
Dividends per Share(DPS)
Book Value per share(BVPS)
Cash Flow per Share(CFPS)
EPS
23
2.27
1.15
17.92
4.27
26
2.36
1.06
16.80
4.16
= Net Income / Comn Shares Outstanding
113,500,000/50,000,000=
2.27
DPS = Dividend Comn Stkholdrs/ Comn Sh/O
57,500,000/50,000,000 =
1.15
BVPS = Total ComEqty/Comn shares Outstdg
896,000,000 / 50,000,000=
17.92
Cash flow per share(CFPS) = Net Incm +Depreciation + Amortization /
Common Share Outstading
213500000/ 50,000,000
=
4.27
Prepared by Waseem Ahmad
STATEMENT OF RETAINED EARNINGS
Changes in retained earnings between balance sheet dates are reported in the
Statement of Retained Earnings.
Retained earnings represent`s a Claim against Assets. Retained earnings are used
for Business Expansion purpose ie., investing in Assets .
The retained earnings is not CASH nor available for payment of Dividends or any
thing else
Micro Drive Inc
(Millions $)
Retained Earning Statement
for the year ending 31 Dec04
Balance of retained earnings , Decmeber 31, 2003
Add Net Income 2004
Less Dividends to common stock holders
Balance in retained earnings, December 31, 2004
Prepared by Waseem Ahmad
710
113.5
(57.5)
766.0
Cash Flow Statement
Cash Flow Statement provides information about the cash receipts and cash payments of a
business during the accounting period because of Operating, Investing and Financing
activities.
A Business’s Net Cash Flow is different from Accounting Profits
Net Cash Flow = Net Income - Non Cash Revenues + Non cash Charges.
Net Income: Other things held constant, Positive net income likely to result positive cash flow
(Net Income can be used for Dividend payments, Increase in Inventories, Finance A/R,
Investment in Fixed Assets, To reduce debts , To buy back common stock etc .
Non cash Adjustment to net income: Non cash revenues and expenses are adjusted.
Changes in Cash Balances :
- Increase in current Assets other than CASH (Invt, A/R) decreases Cash and vice versa
- Increase in Current Liabilities increases CASH and vice versa
- Fixed Assets: Investment in fixed assets reduce cash and vice versa
- Securities Transactions: If a Co issues Stock, Bonds during the year, the funds raised will
increase Cash position, On the other hand if it ( uses cash ) buy back outstanding stock, pay
off debt, dividends to share holders it will reduce the Cash .
Prepared by Waseem Ahmad
Contents of Cash Flow Statement
The Cash Flow statement separates activities into 3 categories
plus a Summary section:
1. Operating Activities: Cash effects of revenue & expense
transactions. Cash effect of those activities which are reported in
Income Statement.(Net Income,Depreciation and changes in
C/A & C/L other than Cash ,S/Term Investment, and Short term
debt).
Cash receipts: Collection from customers for sale of goods
and services, Interest and Dividend received, Other receipts
from operations eg., proceeds from settlement of litigation.
Cash Payments: Payments to suppliers of Merchandise and
Services, including payment to employees.Payment of interest,
Payment of Income taxes, Other expenditure relating to
operations eg., payment in settlement of litigation.
Prepared by Waseem Ahmad
Investing Activities
2 Cash Flow relating to Investing Activities present the cash
effects of transactions involving Plant Assets, Intangible
Assets, and Investments (Investment in or Sale of Fixed
Assets).
Cash Receipts: Cash receipts from selling investments or
plant assets, Cash Collection -- collecting principal
amounts of loans-- (for banking co).
Cash Payments: Payments to acquire investments or plant
assets, Amount Advanced to Borrowers ( for banking co).
Prepared by Waseem Ahmad
Financing Activities
Financing Activities: It includes raising cash by selling short
term investments or by issuing short term debt, long term
debt, or stock. It also includes the impact of Dividend
payment, cash used to buy back outstanding stock or bonds .
Cash Receipts: Proceeds from sale of short term and long
term borrowing, Cash received from Owners eg., from
issuing stock.
Cash Payments: Repayments of amount borrowed
(excluding interest payments), Payments to owners such as
dividends.
Prepared by Waseem Ahmad
What questions Cash Flow statement tries to answer
Financial Managers use this Cash Flow statement along with
the Cash Budget when forecasting the Companies cash
position. Cash flow statement answers the following
questions:
Is the Company generating ENOUGH cash to purchase
additional assets which are required for growth.
 Is the Company generating extra cash that can be used to
repay debts or invested in new products.
Profits reported in Income statements can be manipulated
(doctored) whereas it is far more difficult to manipulate
working capital simultaneously with profits. The Company
can declare profits right up to the point of bankruptcy.
Prepared by Waseem Ahmad
Micro Drive:Statement of Cash Flows for 2004 ($ in Mill)
1 Operating Activities
Cash provided / Used
Net Income b4 preferred dividend
$
117.5
Adjustments
Non Cash Adjustments:
Depreciation
100.0
Due to Change in Working Capital
Increase in A / R (375-315)
(60.0)
Increase in Inventories (615-415)
(200.0)
Increase in A / Payables (60-30)
30.0
Increase in Accruals (140-130)
10.0
Net Cash provided by Operating Activities
($2.5)
Prepared by Waseem Ahmad
2. Long term Investing Activities.
Cash Used to acquire Fixed Assets(130+100) ($230)
Total Funds used by Investing Activities
3 Financing Activities
Sale of Short term Investment (65-0) $ 65.0
Increase in Notes Payables (110-60)
50.0
Increase in Bonds Outstanding (754-580)
174.0
Paymnt of Dvdnt (Comn 57.5+ Prefd 4) (61.5)
Net Cash provided by Financing activities 227.5
SUMMARY:
Net Changes in Cash
($5.0)
Cash at beginning of the year
15
Cash at the End of the year
$ 10
Prepared by Waseem Ahmad
($230)
MODIFYING A/CING DATA FOR MANAGERIAL DECISIONS
Different Companies have different Financial Structures,
Tax situations which can affect Return on Equity. 2
Companies having similar operations appear to be operating
under different efficiency.
Performance of Managers should be judged on the basis of
their performance on the Operating assets which are under
their control. (EBIT to be compared with Operating Assets)
Assets can be classified as:
Operating Assets: Those assets which are used for the core
activities of the business.
Non operating Assets: Used for Non core activities. Eg.,
Cash and short term investment held above level of normal
operations.
Prepared by Waseem Ahmad
Classification of operating assets:
Operating Current Assets: Assets necessary to operate
business eg., Inventories , Accounts receivables
Long term operating Assets: Such as Plant and Equipment.
Note: IF SAME AMOUNT OF PROFIT / CASH FLOW CAN BE GENERATED
WITH LESS AMOUNT OF INVESTMENTS IN OPERATING ASSETS --- LESS
CAPTIAL / FUNDS REQUIRED TO BE PROVIDED BY THE INVESTORS. IT
WILL INCREASE RETURN ON CAPITAL AND LESSON COST OF
CAPITAL.
OPERATING CURRENT LIABILITIES
Fund provided by the Normal Consequence of business are
called operating Current Liabilities e.g., Accounts Payable,
Accrued wages and Taxes etc .
NOTE: THESE ARE FUNDS WHICH ARE NOT PROVIDED
BY THE INVESTOR RATHER GENERATED AS A
CONSEQUENCE OF BUSINESS OPERATIONS.
Prepared by Waseem Ahmad
If a Company needs $100 millions of Assets but it has $10
millions of Accounts Payable and $ 10 millions of Accrued
wages and Taxes then the Investor supplied capital would be
only $ 80 millions. 100 - (10+10) = 80
Operating Working Capital: Current Assets used in
operations are called Operating Working Capital.
Net Operating Working Capital: Operating Working Capital
less Operating Current Liabilities is called Net operating
working capital.
NOWC= All current Assets that do not pay interest MINUS
All current liabilities that do not charge interest.
Or
NOWC= Operating Current Assets MINUS
Operating Current Liabilities.
Prepared by Waseem Ahmad
Cash , Inventories , Accounts receivable are required for
Normal Business operations by all Companies.
Any Short term security which a Company holds results from
INVESTMENT decision I.e not required for Core activities.
Current Liabilities that charge interest such as note payable to
bank, are treated as investor supplied capital where as
current asset Accounts payable / Accruals are as a result of
normal business operation.
NOWC= (Cash+ A/R+ Inventories ) -(A/P + Accruals)
Total Operating Capital: (NOWC) + (Operating LT Assets)
Prepared by Waseem Ahmad
NET OPERATING PROFIT AFTER TAXES (NOPAT)
In order to calculate better measurement of the
performance of the managers we compute NOPAT.
This is amount of profit which a company will generate
if it held no Debt and Financial Instrument.
NOPAT = EBIT (1-Tax rate)
For more complicated tax situations
NOPAT = (Net income before preferred Dividend)+
(Net Interest expense ) (1-Tax rate)
Prepared by Waseem Ahmad
FREE CASH FLOW
NET CASH FLOW = NET INCOME + NON CSH ADJMT
OPERATING CASH FLOW= NOPAT + DEPRECIATION
FCF= The Cash flow actually available for distribution to
Investors after the company has made all the investments in fixed
assets and working capital necessary to sustain ongoing
operations.
In order to make company more valuable the managers should try
to increase the amount of FCF
FCF= Operating Cash Flw - G Investment in Oprting Assets.
Or FCF = NOPAT - Net Investment in Operating Assets.
Prepared by Waseem Ahmad
USES OF FCF
Five Good Uses of FCF
 Pay Interest to debt holders, keeping in mind that the net cost to




the company is the after tax interest expense.
Repay debt holders that is pay off some of the debt
Pay dividends to share holders
Repurchase stock from the share holders
Buy marketable securities or other non operating asset.
FCF is not used for acquiring operating assets
FCF should not be used in unnecessary Investments which do
not Add Value . FCF can also add in Agency Cost.
FCF is the cash available for distribution to Investors. Therefore, the
value of Company primarily dependent upon its expected future FCF.
Prepared by Waseem Ahmad
EVALUATING FCF, NOPAT & OPTNG CAPITAL
Negative FCF is not a sign of worry . Companies normally
in expansion phase or High growth Co can have negative
FCF.
IF NOPAT as well as FCF both are negative than it is sign
of WORRY. It means company is experiencing
OPERATING problems.
WHETHER the GROWTH is Profitable a measure
ROIC is computed ( Return on Invested Capital).
ROIC= NOPAT / OPERATING CAPITAL
IF ROIC > WACC (If ROIC is greater than return investors
demand ) The company is ADDING VALUE.
Prepared by Waseem Ahmad
MVA and EVA
Primary goal of Management is to Maximize share holder
wealth.This will benefit Share holders and result in efficiently
allocating funds in the economy.
The share holder wealth is maximized by MAXIMIZING the
difference between the market value of the stock and the
amount of Equity Capital. It is called MARKET VALUE
ADDED.
MVA= MARKET VALUE OF STOCK MINUS EQUITY
CAPITAL SUPLLIED BY SHARE HOLDERS.
Or
MVA=(Shares outstanding X stock price) Minus
Total Common Equity.
Prepared by Waseem Ahmad
The HIGHER the MVA the better the JOB management doing.
THE MVA is some time defined the total market value of the company
MINUS the total amount of investors supplied capital
MKT Value of (Equity + Debt + Preferred stock) MINUS
Total Common Equity + Debt+Preferred Stock.
MVA Measures the effects of Managerial Actions since the Inception of
the Company.
EVA ECONOMIC VALUE ADDED
EVA focuses on Management performance in a given year.
EVA= NOPAT minus AFTER TAX $ COST OF CAPITAL USED TO
SUPPORT OPERATIONS.
Or
EVA = EBIT(1-T) minus (Operating Capital) X (WACC)
or
EVA = (Operating Capital) x ( ROIC-WACC)
Prepared by Waseem Ahmad
 IF ROIC > WACC then Company will have +ve EVA
 IF WACC > ROIC then new investment in OPERATING CAPITAL






will reduce the firm VALUE.
EVA is an estimate of TRUE economic profit for the period and it
differs SHARPLY from Accounting Profit.
EVA represents the Residual Income that remains after all the
COST of CAPITAL , including Equity Capital has been deducted
whereas Accounting profits are determined without consideration of
equity capital cost.
IN EVA we do not add back Depreciation.
EVA measure the extent to which Company has added to the Share
holders value.
EVA can be determined for all divisions as well as company as a
Whole. It becomes the basis for evaluating performance of
Management at ALL LEVELS.
IF a Company has history of NEGATIVE EVA then probably MVA
will also be negative.
Prepared by Waseem Ahmad
THE CO with Negative EVA can have Positive MVA
provided INVESTORS expects a turnaround in future.
EVA is used for evaluation of Management performance and
management compensation.
MVA Calculations:
2004
2003
Price per share
23
26
Number of Shares (Mill)
50
50
Market Value of Equity
1150
1300
Book Value of Equity
896
840
MVA added= Mkt Value
minus Book Value
254
460
Prepared by Waseem Ahmad
EVA Calculation:
2004
2003
EBIT
Tax rate
40%
NOPAT=EBIT(1-T)
Total Invs Supplied Capital
After Tax cost of Capital
(WACC)
$ Cost of Capital = Capital
X (WACC)
EVA=NOPAT-Capital Cost
ROIC= NOPAT/ Optng Captial
ROIC-Cost of Captl= ROIC-WACC
EVA= Optng Capital(ROIC-WACC)
283.8
263
40%
170.3
1800
11%
157.8
1455
10.8%
198
157.1
(27.7)
9.46%
(1.54%)
(27.7)
Prepared by Waseem Ahmad
0.70
10.85
0.05%
0.7
How to compute Operating Capital
Investor supplied operating capital equals the sum of note payable,
Long term debt, preferred stock, and common equity, less short
term investments.
It could also be calculated as total liabilities and
equity minus accounts payable, accruals and short term
investments. It is also equal to total net operating capital.
Yr 2004= NP 110, LTB 754, PRF STK 40 EQUITY 896 = 1800
YR2003 = 60 , 580, 40, 840 - 65 = 1455
OR FOR 2004 = 2000 - (60 + 140) = 1800
FOR 2003 = 1680 –(30+130+65) = 1455
Prepared by Waseem Ahmad