Chapter 02
Financial Statements
Determinants of Intrinsic Value: Calculating FCF
Sales revenues
−
Operating costs and taxes
−
Required investments in operating capital
Free cash flow
(FCF)
Value =
=
FCF1
FCF2
FCF∞
... +
+
+
(1 + WACC)1
(1 + WACC)2
(1 + WACC)∞
Weighted average
cost of capital
(WACC)
Market interest rates
Cost of debt
Firm’s debt/equity mix
Market risk aversion
Cost of equity
Firm’s business risk
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Financial Statements
Balance Sheet
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Balance Sheet
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Balance Sheet
The basic principles to read Balance Sheet are:

LIQUIDITY: Promptness with which assets are expected time
to be converted into cash

REPAYING PERIOD: Time within which obligations are
expected to be satisfied
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Balance Sheet
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Balance Sheet
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Balance Sheet
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Balance Sheet
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Balance Sheet
•
•
A snapshot of financial position on the last day of a period
Snapshot changes as position changes: B/S may look different at
different times of a period
MicroDrive Inc. December 31 Balance Sheets
(in millions of dollars)
2010
2009
Assets
Cash and equivalents
$10
$15
Short-term investments
$0
$65
Accounts receivable
$375
$315
Inventories
$615
$415
Total current assets
$1.000
$810
Net plant and equipment
$1.000
$870
Total assets
$2.000
$1.680
Liabilities and equity
Accounts payable
Notes payable
Accruals
Total current liabilities
Long-term bonds
Total debt
Preferred stock (400,000 shares)
Common stock (50,000,000 shares)
Retained earnings
Total common equity
Total liabilities and equity
Asset: things that
company owns, listed in
“liquidity” order
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2010
2009
$60
$110
$140
$310
$754
$1.064
$40
$130
$766
$896
$2.000
$30
$60
$130
$220
$580
$800
$40
$130
$710
$840
$1.680
Liabilities & Equity:
claims against
company’s value, listed
in the “maturity” order
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Income Statement
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Income Statement
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Income Statement
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Income Statement
A basic principle to read Income Statement:
DEDUCTING PRINCIPLE


To deduct progressively costs from revenues
following the production- sales cycle
Goals: To show different margins
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Income Statement
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Income Statement
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Income Statement
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Income Statement
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Income Statement
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Income Statement
•
Reflects financial performance during a period
MicroDrive Income Statements for Years Ending December 31
(in millions of dollars)
2010
INCOME STATEMENT
Net sales
Operating costs except depreciation
Earnings before interest, taxes, deprn, and amortization (EBITDA)*
Depreciation
Earnings before interest and taxes (EBIT)
Less interest
Earnings before taxes (EBT)
Taxes
Net Income before preferred dividends
Preferred dividends
Net Income available to common stockholders
Common dividends
Addition to retained earnings
2009
$3.000,0 $2.850,0
$2.616,2 $2.497,0
$383,8
$353,0
$100,0
$90,0
$283,8
$263,0
$88,0
$60,0
$195,8
$203,0
$78,3
$81,2
$117,5
$121,8
$4,0
$4,0
$113,5
$117,8
$57,5
$56,0
$53,0
$64,8
*MicroDrive has no amortization charges.
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Statement of Retained Earnings
MicroDrive Statement of Retained Earnings
(in millions of dollars)
Balance of Retained Earnings, Dec. 31, 2009
Add: Net Income, 2010
Less: Dividends to common stockholders
Balance of Retained Earnings, Dec. 31, 2010
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$710,0
$113,5
-$57,5
$766,0
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Statement of Cash Flows
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Statement of Cash Flows
Net Cash Flow
= Net Income
– Noncash Revenues
+ Noncash Charges
MicroDrive Statement of Cash Flows for Years Ending Dec. 31
(in millions of dollars)
Operating Activities
Net Income before preferred dividends
Noncash adjustments
Depreciation and amortization
Due to changes in working capital
Increase in accounts receivable
Increase in inventories
Increase in accounts payable
Increase in accruals
Net cash provided by operating activities
($60,0)
($200,0)
$30,0
$10,0
($2,5)
Long-term investing activities
Cash used to acquire fixed assets
($230,0)
$117,5
$100,0
Financing Activities
Sale of short-term investments
Increase in notes payable
Increase in bonds
Payment of common and preferred dividends
Net cash provided by financing activities
$65,0
$50,0
$174,0
($61,5)
$227,5
Net change in cash and equivilents
Cash and securities at beginning of the year
($5,0)
$15,0
Cash and securities at end of the year
$10,0
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What are the five uses of FCF?
1. Pay interest on debt.
2. Pay back principal on debt.
3. Pay dividends.
4. Buy back stock.
5. Buy nonoperating assets (e.g., marketable
securities, investments in other companies,
etc.)
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Determining Free Cash Flow (FCF)
Operating Cash Flow – Investment in Operating Capital
NOPAT (Net Operating Profit After Taxes)

Amount of profit a company would generate if it had no debt and held no
financial assets

Take out impacts of financing & investing decisions to have pure measure of
operating performance
NOPAT = EBIT(1-Tax Rate)
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Free Cash Flows (FCF)

Cash flows can not be maintained over time unless depreciated fixed assets
are replaced, so management is not completely free to use net cash flows.

Free Cash Flows is 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 operation
NOPAT = EBIT(1-Tax Rate)
FCF = NOPAT – Net investment in operating capital
Gross Investment = Net Investment + Depreciation
FCF = (NOPAT + Depreciation) – Gross Investment in
operating capital
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Operating Capital
Total net operating capital = Net operating working capital
+ Operating long term assets
Net operating working capital = Operating current asset
– Operating current liabilities
Net operating working capital =
(Cash + Accounts Receivable + Inventories)
- (Accounts Payable + Accruals)
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Free Cash Flows (FCF)
- MicroDrive Illustration
EBIT
(1-Tax Rate)
NOPAT
283,8
0,6
170,28
2010
Cash
Accounts Receivable
Investories
Operating Current Assets
minus
Accounts Payable
Accruals
Operating Current Liabilities
Net Operating Working Capital
plus
Operating Long Term Assets
Total Net Operating Capital
Net Investment in Opr Capital
NOPAT
Net Investment
170,28
345 (-)
FCF
(175)
2009
10
375
615
1.000
15
315
415
745
60
140
200
800
30
130
160
585
1.000
1.800
345
870
1.455
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Return on Invested Capital
ROIC =
NOPAT
Operating Capital
MicroDrive Illustration
ROIC =
170.3
 0.0946
1,800
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Market Value Added (MVA)

To incorporate stock prices in the analysis as the primary goal of
management is to maximize the firm’s value, hence the outstanding shares
times stock price

Measures the effects of managerial actions since the inception of the
company
MVA = Market Value of Stock – Equity capital supplied
= (shares o/s)(stock price) – Total Common Equity
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Economic Value Added (EVA)

Focuses on managerial effectiveness in a given year
EVA = Net Operating Profit After Taxes (NOPAT)
- After-tax dollar cost of capital used to support operations
= EBIT(1-Tax Rate) – (operating capital)(WACC)
EVA = (Operating capital)(ROIC – WACC)
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MVA & EVA - Illustration
2010
MVA =
=
=
2010
MVA =
2009
MVA =
MVA =
2010
EVA
2010
EVA
2009
EVA
2009
EVA
x
x
$1.150
# of shares
50
-
Total common equity
$896
$896
x
x
$1.300
# of shares
50
-
Total common equity
$840
$840
$254
=
=
2009
Stock price
$23,00
Stock price
$26,00
$460
=
=
=
=
NOPAT
$170,3
$170,3
-$27,7
-
Operating Capital
x
$1.800
x
$198,0
Weighted average cost of capital
11%
=
=
=
=
NOPAT
$157,8
$157,8
$0,7
-
Operating Capital
x
$1.455
x
$157,1
Weighted average cost of capital
11%
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