Business Finance
Michael Dimond
What CF do stockholders really buy?
• Dividend?
• Net Income?
• Free Cash Flow?
• To understand cash flow, you must understand financial
statements and what the figures represent
Michael Dimond
School of Business Administration
Discounting the cash flows is the easy part…
• Computing the correct cash flow is a little more complicated.
• Trying to accurately predict the future (plus or minus a little )
• Trying to use accounting figures to show economic reality
• You must understand what the number represents and what went into it
before you can present an accurate valuation.
• Remember the financial statements?
• Income statement
• Balance sheet
• Statement of cash flows
• You will be computing cash flows…
• from financial statements to evaluate existing businesses
• from pro forma financials to evaluate proposals and scenarios
• You may need to measure sensitivity to certain inputs
• What if sales or costs are less than (or more than) expected?
• What if growth is less than (or more than) expected?
Michael Dimond
School of Business Administration
Cash Flows
• NOPAT = Net Operating Profit After Taxes
EBIT(1-t)
• OCF = Operating Cash Flow
NOPAT + Depreciation Expense
Why doesn’t this work: NI + Interest + Depreciation Expense
• NOTE: Operating Cash Flow is not the same as Cash Flow from Operations
• FCF = Free Cash Flow
OCF – Net Cash Investment in Operating Capital
• Free Cash Flow: The cash generated which is available to satisfy the
needs of lenders and the wants of investors.
• FCFE = Free Cash Flow for Equity
FCF – Net Cash Flow to Debt
• Free Cash Flow to for Equity: The cash generated which is available
to satisfy the wants of investors.
Michael Dimond
School of Business Administration
Working with financial statement data
• Accounting figures are distorted for several reasons
• Rules & laws
• Assumptions & “Generally Accepted Accounting Principles”
• Inaccuracies & manipulations
• Financial Analysis tries to get those numbers to represent
economic reality
• Non-cash “expenses”
• Categorization of revenues and expenses
• Operating Cash Flow (OCF) is the basic starting point of all
valuation efforts
•
•
•
•
Need to understand the figures being used
OCF = NOPAT + Depreciation Expense
NOPAT = EBIT(1-t)
:. OCF = EBIT(1-t) + Depreciation Expense
Michael Dimond
School of Business Administration
EBIT
• Given a bunch of financial data, how do you compute EBIT?
• Top down or bottom up?
• Bottom up is easier to remember
• Top down helps you understand better
• Building a pro forma income statement
Michael Dimond
School of Business Administration
Tax Rate
• Tax expense ÷ EBT (Earnings Before Taxes)
•
•
•
•
EBT is also called Net Profit Before Taxes
Average tax rate
Marginal tax rate
Typical tax rates in finance problems will be 34%, 35% or 40%. This is not
true in real life.
Michael Dimond
School of Business Administration
Depreciation
• What is depreciation?
• Straightline vs MACRS
• Why do we adjust for depreciation when computing OCF?
• What about other non-cash expenses?
Michael Dimond
School of Business Administration
Operating Cash Flow (OCF)
• EBIT = …
• NI + Tax + Interest
• Sales – Direct Costs – Indirect Costs – Depreciation
• Sales – Total Variable Costs – Total Fixed Costs – Depreciation
• Tax rate = …
• Might be given (e.g. 34%, 35%, 40%)
• Might be derived from Tax ÷ EBT
• EBT = EBIT - Interest
• NOPAT = EBIT(1-t)
• OCF = NOPAT + Depreciation Expense
Michael Dimond
School of Business Administration
Michael Dimond
School of Business Administration
Michael Dimond
School of Business Administration
Michael Dimond
School of Business Administration
Operating Cash Flow (OCF)
• From the income statement
• EBIT x (1-t) + Depreciation = OCF
• 370 x (1-0.4) +
100
= 322
Michael Dimond
School of Business Administration
OCF → FCF
• FCF = Free Cash Flow
• Free Cash Flow: The cash generated which is available to satisfy the
needs of lenders and the wants of investors.
OCF – Net Cash Investment in Operating Capital
• What is operating capital?
• Assets used for operating purposes
• Not financial assets
• Operating assets can be classified as Fixed Assets and Current Assets
• Fixed assets are normally capitalized, so depreciation is involved
• Current Assets are also called Working Capital. We really care about Net Working
Capital
• Net Working Capital is Current Assets – Current Liabilities
• Are all current liabilities operating items?
• NWC for our purposes will be limited to operating items only, so…
NWC = Current Assets – (Accounts Payable + Accruals)
which should be the same as
NWC = Current Assets – (Current Liabilities – Non-operating CLs)
Michael Dimond
School of Business Administration
OCF → FCF
• OCF – Δ GFA – Δ NCA = FCF
• 322 – 300 –
0 = 22
• Net Fixed Assets
increased 200,
and depreciation
was 100, so
Δ GFA = 300
• How much did
current assets change?
• How much did AP &
Accruals change?
Michael Dimond
School of Business Administration
OCF → FCF
• OCF – ΔGFA – ΔNCA = FCF
• 322 – 300 –
0 = 22
• Current Assets
increased 100, so
Δ CA = 100
• CLOP (AP + Accruals) was
700 in 2011 and
800 in 2012, so
Δ CLOP = 100
• We need the Net amount,
so we subtract:
Δ CA - Δ CLOP = Δ NCA
100 - 100 = 0
Michael Dimond
School of Business Administration
Capital Budgeting Decisions
• To make an objective business decision, we have to
understand the scenario, the relevant cash flows, the change
in cash flow caused by the decision, and the net present
value of those incremental cash flows.
• At its simplest, it might be like this capital budget proposal:
9% Hurdle Rate
YEAR
0
(1,110,400)
Initial Investment
Incremental CF
Terminal Value
Total CF
PV
NPV (Sum of PVs, less Initial Investment)
IRR
PBP
1
2
3
4
257,200
344,400
274,200
258,800
(1,110,400)
257,200
(1,110,400.0000) 235,963.3028
100,900.3907
12.24%
3.91
344,400
289,874.5897
274,200
211,732.7102
258,800
183,340.4446
5
274,800
172,000
446,800
290,389.3434
• Is life ever that simple?
Michael Dimond
School of Business Administration
Scenario
• How long is the timeline?
• What happens, and when?
Proposal:
0
Sell old machine
Buy new machine
Install new machine
Increase NWC needs
1
2
3
4
Reduced
Operating
Costs
Reduced
Operating
Costs
Reduced
Operating
Costs
Reduced
Operating
Costs
5
Reduced
Operating
Costs
Sell “new” machine
Reduce NWC needs
Michael Dimond
School of Business Administration
Relevant Cash Flows
• What are the cash inflows and outflows?
Proposal:
0
Sell old machine
Buy new machine
Install new machine
Increase NWC needs
1
2
3
4
Reduced
Operating
Costs
Reduced
Operating
Costs
Reduced
Operating
Costs
Reduced
Operating
Costs
5
Reduced
Operating
Costs
Sell “new” machine
Reduce NWC needs
Michael Dimond
School of Business Administration
Relevant Cash Flows
• What are the cash inflows and outflows?
Proposal:
0
Sell old machine
Buy new machine
Install new machine
Increase NWC needs
1
2
3
4
Reduced
Operating
Costs
Reduced
Operating
Costs
Reduced
Operating
Costs
Reduced
Operating
Costs
5
Reduced Op. Costs
Sell “new” machine
Reduce NWC needs
$147,000 Inflow
$25,000 Inflow
__________________
TV = $172,000
Inflow
$264,600 Inflow
$1,200,000 Outflow
$150,000 Outflow
$25,000 Outflow
_________________
Io = $1,110,400
Outflow
$350k
$350k
$350k
$350k
$350k
• Is that all?
• We also need to consider the effect which depreciation has on tax expense.
Michael Dimond
School of Business Administration
Relevant Cash Flows
• Depreciation is a non-cash expense, but it does have an
effect on tax expense (therefore depreciation has an effect on
a cash flow).
CF for New Machine
YEAR
Reduction in Operating Cost
Depreciation
Net Profit before Tax
Tax (@40%)
Net Profit After Tax
Operating Cash Flow
0
1
350,000
270,000
80,000
32,000
48,000
318,000
2
350,000
432,000
(82,000)
(32,800)
(49,200)
382,800
3
350,000
256,500
93,500
37,400
56,100
312,600
4
350,000
162,000
188,000
75,200
112,800
274,800
5
350,000
162,000
188,000
75,200
112,800
274,800
Michael Dimond
School of Business Administration
Incremental Cash Flows
• What & when would the BAU cash flows be?
• No cost savings
• What about the effect which depreciation would have had on tax expense?
• What salvage value would the existing (BAU) equipment have after year 5?
CF for Old Machine
YEAR
0
Depreciation
Net Profit before Tax
Tax (@40%)
Net Profit After Tax
Operating Cash Flow
1
2
3
4
152,000
(152,000)
(60,800)
(91,200)
60,800
96,000
(96,000)
(38,400)
(57,600)
38,400
96,000
(96,000)
(38,400)
(57,600)
38,400
40,000
(40,000)
(16,000)
(24,000)
16,000
5
-
• What is the difference between BAU and the proposal cash
flows?
Incremental CF
YEAR
New Machine CF
Old Machine CF
Incremental CF (Difference)
0
1
318,000
60,800
257,200
2
382,800
38,400
344,400
3
312,600
38,400
274,200
4
274,800
16,000
258,800
5
274,800
274,800
Michael Dimond
School of Business Administration
DCF analysis
• What is the hurdle rate?
• 9.0%
• What/when are the incremental cash flows?
9% Hurdle Rate
YEAR
0
(1,110,400)
Initial Investment
Incremental CF
Terminal Value
Total CF
PV
NPV (Sum of PVs, less Initial Investment)
IRR
PBP
1
2
3
4
257,200
344,400
274,200
258,800
(1,110,400)
257,200
(1,110,400.0000) 235,963.3028
100,900.3907
12.24%
3.91
344,400
289,874.5897
274,200
211,732.7102
258,800
183,340.4446
5
274,800
172,000
446,800
290,389.3434
Michael Dimond
School of Business Administration
Objective decision
• Do the incremental cash flows have a positive NPV?
• Yes, $100,900
• Is the IRR greater than the hurdle rate?
• Yes, 12.2% > 9.0%
• Is the payback period acceptable?
• Depends on what management says about PBP, but NPV and IRR should be
used to make the actual decision. I use PBP just to show a complete picture.
9% Hurdle Rate
YEAR
0
(1,110,400)
Initial Investment
Incremental CF
Terminal Value
Total CF
PV
NPV (Sum of PVs, less Initial Investment)
IRR
PBP
1
2
3
4
257,200
344,400
274,200
258,800
(1,110,400)
257,200
(1,110,400.0000) 235,963.3028
100,900.3907
12.24%
3.91
344,400
289,874.5897
274,200
211,732.7102
258,800
183,340.4446
5
274,800
172,000
446,800
290,389.3434
Michael Dimond
School of Business Administration
Michael Dimond
School of Business Administration