# Chapter 3 Lecture-1

```Chapter 3 Lecture
Chapter 3 is concerned with using financial statements to estimate the cash flow (cash in
minus cash out) of the firm. One of the key aspects of estimating cash flow involves the
effect depreciation has on reducing taxable income, which reduces the firm’s taxes
which, in turn, increases the cash the firm can keep. The net effect is that depreciation
expense increases the firm’s cash flow by reducing tax expense. A very specific method
is used to compute depreciation for tax purposes. It is called Modified Accelerated Cost
Recovery system (MACRS). It is loosely related to the double declining balance method
of depreciation used for financial reporting purposes.
MACRS
MACRS classified long-term assets (those expected to last more than one year) into a
number of classes. These are shown in Table 3.1 on page 93 of your text. Take a minute
to review the table.
Suppose you own a plant nursery and your firm buys a light-duty truck to make deliveries
to customers. Suppose further this truck costs \$50,000. You examine the table and find
the truck is listed in the 5-year property class. This means the truck must be depreciated
as a 5-year asset for tax purposes. Its worth noting that IRS regulations allow you to
depreciate not just the cost of an asset (\$50,000 in our example), but also any shipping
and installation charges. Let’s assume all that is already included in the \$50,000 price of
the truck.
Our next step is to compute the depreciation-expense-deduction the IRS allows you to
take each year. Now we must examine Table 3.2 on page 94 which provides the
depreciation rates for each of the property classes listed in Table 3.1. Since your truck is
in the 5-year property class, we will be looking at the column labeled “5 years”.
Before we proceed, notice something interesting. The truck is in the 5-year class, but if
you look at the 5-year column in the table, you will notice the truck is actually going to
be depreciated over 6 years, not 5. In fact, all the columns in the table have one extra
year. Why is that?
The reason is the half-year convention. As I mentioned previously, MACRS depreciation
rates are loosely based on the double declining method of accounting. Recall that when
an asset is depreciated using double declining balance, it is being depreciated at twice the
straight line rate. For an asset expected to last 5 years, the straight line method would tell
us to depreciate 1/5th (or 20%) of the asset each year. If double declining balance were
used, we would depreciate 40% of the assets cost the first year. Now look at the
depreciation rate for year 1 in the 5-year column. It says 20%, not 40% as we would
expect. The reason for this is that the IRS gives everyone ½ year’s depreciation the first
year regardless of when the asset is purchased. Some firm’s will buy their trucks at the
beginning of the year, some will buy their’s at the end. The IRS assumes on average,
firm owners will buy their trucks in the middle of the year. This is called the half-year
convention. Because of the half-year convention, there will be a portion of the asset that
has not been depreciated after the 5th year. This remaining depreciation is taken the 6th
year.
Finding the depreciation expense under MACRS is easy. All you do is multiply the
assets depreciable basis (cost + shipping +installation) by the percentage rate shown in
the table for that year. For our \$50,000 truck, the depreciation expense we could claim
each year would be
Year
1
2
3
4
5
6
Rate
20%
32%
19%
12%
12%
5%
Depreciation Expense
\$50,000 X .20 = \$10,000
\$50,000 X .32 = \$16,000
\$50,000 X .19 = \$9,500
\$50,000 X .12 = \$6,000
\$50,000 X .12 = \$6,000
\$50,000 X .05 = \$2,500
Notice if we sum the depreciation expense for all six years, we get \$50,000, the cost of
the truck.
Free Cash Flow
The free cash flow of the firm is the amount of cash left after the firm pays its operating
expenses, taxes, and pays for any shareholder-wealth increasing investments in current
and fixed assets. What’s left over is cash the firm does not need and is therefore
available for distribution to investors. Remember investors include both the debt holders
and the equity holders of the firm. The debt holders are entitled to receive the amount
they lent the firm plus interest. The equity holders should (notice I did not say will)
receive what remains since the firm has no use for it. This remainder can be paid to
shareholders in the form of dividends or the firm can use it to purchase the firm’s stock
from shareholders in the open market. My personal preference would be for the firm to
purchase its own shares in the open market. That way, there’s no drastic change in
dividends (investors don’t like a lot of volatility in dividends) and only those
shareholders willing to sell shares receive cash. This is important. Cash disbursements
to shareholders of any kind are taxable. As a shareholder, I may not want a dividend just
now because I may be in a high tax bracket and after I pay tax on the dividend relatively
little will be left. Having the firm repurchase shares allows only those shareholders
willing to pay the tax now (on any capital gains they have realized) to do so.
Sometimes managers get confused about what they are supposed to do with free cash
flow. They are supposed to find a way to get that cash to investors. However, sometimes
managers “forget” that and instead spend the cash in ways that have nothing to do with
maximizing shareholder wealth. For example, they may use the cash to pay for
perquisites for themselves (e.g., expensive and elaborately decorated apartments, “loans”
to managers that never have to be repaid, jets, limousines, etc.). Sometimes managers
will use these funds to make diversifying acquisitions (Peter Lynch, former manager of
Fidelity’s Magellan fund calls these “deworsifying” acquisitions because they almost
always result in lower share prices: managers simply aren’t competent to manage firms
outside their own industry) or to simply to increase the size of the firm even those these
may not increase shareholder wealth.
Why would a manager want to make a diversifying acquisition or increase the size of her
firm if these actions do not increase shareholder wealth? Managers sometimes make
diversifying acquisitions to reduce the volatility of the firm’s cash flow. That sounds like
a good idea doesn’t it? Actually diversifying acquisitions are usually a terrible idea at the
firm level. If shareholders want diversification, they can achieve it much more easily and
cheaply on their own simply by purchasing shares of firms in other industries.
Why would a manager want to increase firm size even though this may not be consistent
with maximizing shareholder wealth. A manager might do this because she believes that
her compensation is tied, at least in part, to the size of the firm. Again, managers are not
perfect agents for shareholders because, just like us, they are human.
Measuring Free Cash Flow
The method for finding a firm’s free cash flow is shown both in the text (see pages 98
through 102) and in the PowerPoint slides for chapter 3. However I will provide a short
exposition of the formula for free cash flow here. My purpose here is to highlight the
relationships between free cash flow and the variables in the formula for it. Free cash
flow equals
FCF = OCF – NFAI - NCAI
Where OCF equals operating cash flow: Operating cash flow results from the firm
selling and producing its product or service. Usually, this will be the firm’s major cash
inflow. Operating cash flow equals
OCF = EBIT(1 – Tax Rate) + Depreciation Expense
NFAI stands for net fixed asset investment. NFAI is the amount the firm spent on fixed
assets during the most recent year. Net fixed assets equals
NFAI = Change in Gross Fixed Assets
In words, NFAI = Gross fixed assets for most recent year minus gross fixed assets for the
previous year
NCAI stands for net current asset investment. This represents the amount the firm spent
on current assets during the most recent year. Net current asset investment equals
NCAI = Change in CA – (Change in (A/P + Accruals))
In words, NCAI equals the difference between current assets in the current year and
current assets in the previous year minus the sum of accounts payable and accruals in the
current year minus that same sum in the most recent year.
Let’s spend some time looking at the NCAI formula. The change in current assets
represents the amount of cash the firm spent on current assets. However, the firm did not
have to use its own cash to fund the change in current assets. It was able to borrow some
of that amount from its suppliers in the form of accounts payable and its workers and the
government in the form of wages and taxes payable. So the difference, NCAI, represents
the amount of its own money the firm spent on current assets after the interest-free loans
provided by suppliers, workers and governments.
You might wonder why the formula isn’t simply NCAI = Change in CA – Change in CL.
There is a very good reason for that. First, we only want to include those current
liabilities that spontaneously change when current assets change (the short-term notes
payable appearing in the current liabilities section do not spontaneously change with
current assets: the only way notes payable changes is when the firm purposefully
borrows from a bank). Second, notes payable represents an obligation to an interestpaying investor in the firm (in this case a bank). In this sense, the funds raised through
short-term notes payable are not “free”. The firm must pay these funds back with
interest. An interesting exercise is to imagine what would happen to the free cash flow
calculation if notes payable were mistakenly included in the formula as a current liability.
Would this cause free cash flow to be overstated or understated? If you guessed
overstated, you would be correct. If effect, this would mistakenly increase the amount of
“free” money available to the firm, thereby reducing the amount of the firm’s own money
spent on current assets, resulting in a higher free cash flow. If effect, we would be
classifying short-term bank loans as interest free by mistake implying banks were not
really investors in the firm. We would be misled into believing the firm had more free
cash flow than it did. But bank loans are not free and do not spontaneously rise with
current assets so they are not included in the calculation of free cash flow.
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