Chapter 7 Accounting for Financial Management Topics in Chapter

Chapter 7
Accounting for Financial Management
Topics in Chapter
 Balance sheet
 Income statement
 Statement of cash flows
 Accounting income versus cash flow
 MVA and EVA
 Corporate taxes
Operating current assets -- the CA needed to support operations.
 Op CA include: cash, inventory, receivables.
 Op CA exclude: short-term investments, because these are not a
part of operations.
Operating current liabilities-- the CL resulting as a normal part of
 Op CL include: accounts payable and accruals.
 Op CL exclude: notes payable, because this is a source of
financing, not a part of operations.
Net Operating Working Capital (NOWC) –operating working capital
supplied with investor funds
NOWC = (cash + AR + Invent.) – (AP + accruals)
NOWC09 =
NOWC08 =
Total net operating capital (also called operating capital)
--adding short-term and long-term operating assets.
Operating Capital= NOWC + Net fixed assets
Operating Capital 2009:
Operating Capital 2008:
Net Operating Profit after Taxes (NOPAT)
 A measure of profit generated from operations
 The amount of profit generated if no debt and no financial assets.
Note Net Income = Accounting Profit
 NI does not reflect performance of operations manager
NI could be small because of large debt and does not reflect
NOPAT = EBIT(1 - tax rate)
Free cash flow (FCF)-- the amount of cash available from operations for
distribution to all investors (including stockholders and debtholders)
after making the necessary investments to support operations.
After-tax operating profit minus new investment in working capital and
fixed assets.
Why is FCF important?
A company’s value depends upon the amount
of its expected future FCFs.
Five uses of FCF:
FCF = NOPAT – Net Investment in Operating Capital
where Net Invest. In Op Cap = Op Cap 09 – Op Cap 08
(in our example)
Net Invest. In Op Cap =
FCF 09 =
If -(NOPAT) & -(FCF) 
If +(NOPAT) & -(FCF) 
If +(NOPAT) & +(FCF) 
Is the firm adding value during the period?
Two ways to test:
1. Test if return on investment in operating capital exceeds
required return
2. Test if positive contribution to shareholder wealth
1. Return on Invested Capital (ROIC)
Operating Capital
We will compare ROIC to WACC.
Recall, WACC is the weighted average cost of capital (debt,
common and preferred stock). WACC indicates the rate of return
that investors require.
If ROIC > WACC  firm is adding value.
ROIC09 =
ROIC08 =
The firm’s cost of capital is 10.8% in 2008 and 11% in 2009. Did the
growth add value?
No. In 2009, the ROIC of 9.46% < WACC of 11%.
Investors did not get the return they require.
Note: High growth usually causes negative FCF (due to investment
in capital), but that’s ok if ROIC > WACC. For example, Home
Depot had high growth, negative FCF, but a high ROIC.
Yes. In 2008, the ROIC of 10.85% > WACC of 10.8%.
 Investors barely received the return they require.
2. Economic Value Added (EVA)
 Measures whether an investment contributes positively to
shareholder’s wealth.
EVA = NOPAT – (WACC × capital)
Rule: If EVA > 0
→ firm is adding value
The capital investment can be in a project, or could be in the entire
company (usually measured as Total Net Operating Capital).
Note: We call (WACC × capital) the dollar cost of capital
How does EVA differ from Net Income (NI)?
NI measures residual income that remains after the cost of debt capital is
accounted for (in the income statement).
NI accounts for accounting costs.
EVA measures residual income that remains after the cost of all capital
is accounted for (this includes equity capital).
This is important because equity capital has a cost, an opportunity
cost—shareholders could have invested in something else and received a
return instead of providing capital for the firm.
 EVA accounts for shareholders’ opportunity cost and not just
accounting costs.
Using: EVA = NOPAT – (WACC × capital)
EVA09 =
→ not adding value
EVA08 =
→ barely adding value
Note: EVA > 0 ↔ ROIC > WACC
firm is adding value