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Cash Flow And Leverage(12-13)

Professor Trainor

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Video: Nickel

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12-3

Cash Flow Versus Accounting Profit

Capital budgeting concerned with cash flow, not accounting profit.

To evaluate a capital investment, we must know:

Incremental cash outflows of the investment (marginal cost of investment), and

Incremental cash inflows of the investment (marginal benefit of investment).

The timing and magnitude of cash flows and accounting profits can differ dramatically.

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Cash Flow and Non-Tax Expenses

Accountants charge depreciation to spread a fixed asset’s costs over time to match its benefits.

Capital budgeting analysis focuses on cash inflows and outflows when they occur.

Non-cash expenses affect cash flow through their impact on taxes:

• Compute after-tax net income and add depreciation back, or

• Ignore depreciation expense but add back its tax savings.

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Assume a firm purchases a fixed asset today for $30,000

Plans to depreciate over 3 years using straight-line method

Firm will produce 10,000 units/year

Costs $1/unit

Sells for $3/unit

Firm pays taxes at a 40% marginal rate

$6,000Net income

$16,000Cash flow = NI + deprec

(4,000)Taxes (40%)

$10,000Pre-tax income

(10,000)Depreciation

$20,000Gross profits

(10,000)Cost of goods

$30,000Sales

Adding non-cash expenses back to after-tax earnings

$4,000Depreciation tax savings

$16,000Cash Flow

$12,000Aft-tax income

(8,000)Taxes (40%)

$20,000Pre-tax income

(10,000)Cost of goods

$30,000Sales

Find after-tax profits, add back non-cash charge tax savings

Simplest and most common technique:Add depreciation back in.

Two Methods of Handling Depreciation to Compute Cash Flow

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Depreciation

Accelerated depreciation methods (such as MACRS) increase the present value of an investment’s tax benefits.

Relative to MACRS, straight-line depreciation results in higher reported earnings early in an investment’s life.

For capital budgeting analysis, the depreciation method for tax purposes matters

most.

Many countries allow one depreciation method for tax purposes and another for reporting

purposes.

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The Initial Investment Initial cash flows:

• Cash outflow to acquire/install fixed assets• Cash inflow from selling old equipment • Cash inflow (outflow) if selling old

equipment below (above) tax basis generates tax savings (liability)

An example....

Tax rate = 40%

New equipment costs $10 million,

$0.5 million to install

Old equipment fully depreciated, sold for $1

million

Initial investment: outflow of $10.5 million, and after-tax inflow of $0.60 million from

selling the old equipment

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Working Capital Expenditures Many capital investments require additions

to working capital.• Net working capital (NWC) = current

assets – current liabilities.• Increase in NWC is a cash outflow;

decrease a cash inflow.

• An example…• Operate booth from November 1 to January 31• Order $15,000 calendars on credit, delivery by

Nov 1• Must pay suppliers $5,000/month, beginning Dec

1 • Expect to sell 30% of inventory (for cash) in Nov;

60% in Dec; 10% in Jan• Always want to have $500 cash on hand

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Working Capital for Calendar Sales Booth

(4,000)+500+500NAMonthly in WC

(3,000)1,0005000Net WC

5,00010,00015,0000Accts payable

01,50010,50015,0000Inventory

$0$500$500$500$0Cash

Feb 1Jan 1Dec 1Nov 1Oct 1

($5,000)($5,000)($5,000)$0Payments

($500)Net cash flow

$1,500[10%]

$9,000[60%]

$4,500[30%]

$0Reduction in inventory

Jan 1 to Feb 1

Dec 1 to Jan 1

Nov 1 to Dec 1

Oct 1 to Nov 1

Payments and inventory

($500) +$4,000 ($3,000)

0

0

+3,000

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Terminal Value

Terminal value is used when evaluating an investment with indefinite life-span:

Construct cash-flow forecasts for 5 to 10

years

Forecasts more than 5 to 10 years have

high margin of error; use terminal value

instead.

• Terminal value is intended to reflect the value of

a project at a given future point in time.

• Large value relative to all the other cash flows of the project.

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Terminal Value

Different ways to calculate terminal values:

• Use final year cash flow projections and assume that

all future cash flow grow at a constant rate;

• Multiply final cash flow estimate by a market multiple, or

• Use investment’s book value or liquidation value.

$3.25 Billion$2.5 Billion$1.75 Billion$1.0 Billion$0.5 Billion

Year 5Year 4Year 3Year 2Year 1

JDS Uniphase cash flow projections for acquisition of SDL Inc.

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Terminal Value of SDL Acquisition

67.48$1.1

2.68$

1.1

25.3$

1.1

5.2$

1.1

75.1$

1.1

1$

1.1

5.0$554321

$68.20.050.10

$3.41PVor ,

grCF

PV 51t

t

Assume that cash flow continues to grow at 5% per year (g = 5%, r = 10%, cash flow for year 6 is $3.41 billion):

• Terminal value is $68.2 billion; value of entire project is:

• $42.4 billion of total $48.7 billion from terminal value

• Using price-to-cash-flow ratio of 20 for companies in the same industry as SDL to compute terminal value• Terminal Value = $3.25 x 20 = $65 billion• Caveat : market multiples fluctuate over time

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Incremental Cash Flow

Incremental cash flows versus sunk costs:

Capital budgeting analysis should include only incremental costs.

• An example…• Norman Paul’s current salary is $60,000 per year

and he expects it to increase at 5% each year.• Norm pays taxes at flat rate of 35%.• Sunk costs: $1,000 for GMAT course and $2,000

for visiting various programs• Room and board expenses are not incremental to

the decision to go back to school

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Incremental Cash Flow

At end of two years assume that Norm receives a salary offer of $90,000, which increases at 8% per year

• Expected tuition, fees and textbook expenses for next two years while studying MBA: $35,000

• If Norm worked at his current job for two years, his salary would have increased to $66,150:

• Yr 3 net cash inflow: $90,000 - $66,150 = $23,850• After-tax inflow: $23,850 x (1-0.35) = $15,503• Yr 4 cash inflow:• MBA has substantial positive NPV value if 30 yr analysis

period

150,66$05.1000,60$ 2

032,18$35.0105.1000,60$08.1000,90$ 3

What about Norm’s opportunity cost?

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Video: Rajan

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12-16

Capital RationingCan a firm accept all investment projects with

positive NPV?

Reasons why a company would not accept all projects:

Limited availability of skilled personnel to be involved with all the projects;

Financing may not be available for all projects.

Companies are reluctant to issue new shares to finance new projects because of the

negative signal this action may convey to the market.

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Operating Leverage

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Degree of Operating Leverage

The degree of operating leverage (DOL) measures the

sensitivity of changes in EBIT to changes in Sales.

A company’s DOL can be calculated in two different

ways: One calculation will give you a point estimate,

the other will yield an interval estimate of DOL.

Only companies that use fixed costs in the production

process will experience operating leverage.

Operating Leverage

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Operating Leverage

Degree of Operating Leverage

Scenario 1 Scenario 2 Scenario 3

Sales Decrease Sales Remain Sales Increase

10.0% Unchanged 10.0%

Net Sales 630,000$ 700,000$ 770,000$

Less: Variable Costs

(60% of Sales) 378,000 420,000 462,000

Less: Fixed Costs 200,000 200,000 200,000

EBIT 52,000 80,000 108,000

Ebit Decreases Ebit Increases

35.0% 35.0%

Effects of Operating Leverage on the Income Statement

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Interval Estimate of DOL

DOL = % Change in EBIT = 35% = 3.50 % Change in Sales 10%

Because of the presence of fixed costs in the firm’s production process, a 10% increase in Sales will result in a 35% increase in EBIT. Note that in the absence of operating leverage (if Fixed Costs were zero), the DOL would equal 1 and a 10% increase in Sales would result in a 10% increase in EBIT.

Operating Leverage

Degree of Operating Leverage

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Financial leverage results from the presence of

fixed financial costs in the firm’s income stream.

Financial leverage can therefore be defined as the

potential use of fixed financial costs to magnify the

effects of changes in EBIT on the firm’s EPS.

The two fixed financial costs most commonly found

on the firm’s income statement are (1) interest on

debt and (2) preferred stock dividends.

Financial Leverage

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Financial Leverage

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Degree of Financial Leverage The degree of financial leverage (DFL) measures the

sensitivity of changes in EPS to changes in EBIT.

Like the DOL, DFL can be calculated in two different

ways: One calculation will give you a point estimate,

the other will yield an interval estimate of DFL.

Only companies that use debt or other forms of fixed

cost financing (like preferred stock) will experience

financial leverage.

Financial Leverage

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Degree of Financial Leverage

Financial Leverage

Scenario 1 Scenario 2 Scenario 3

EBIT Dcrease Sales Remain EBIT Increase

35.00% Unchanged 35.00%

EBIT 52,000 80,000 108,000

Less: Interest Expense 20,000 20,000 20,000

EBT 32,000 60,000 88,000

Less: Taxes (30%) 9,600 18,000 26,400

Net Income 22,400$ 42,000$ 61,600$

EPS (42,000 shares) 0.53$ 1.00$ 1.47$

EPS Decreases EPS Increases

46.67% 46.67%

Effects of Financial Leverage on the Income Statement

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Interval Estimate of DFL

DFL = % Change in EPS = 46.67% = 1.33% Change in EBIT 35.00%

In this case, the DFL is greater than 1 which

indicates the presence of debt financing. In

general, the greater the DFL, the greater the

financial leverage and the greater the financial risk.

Financial Leverage

Degree of Financial Leverage

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Total leverage results from the combined effect

of using fixed costs, both operating and

financial, to magnify the effect of changes in

sales on the firm’s earnings per share.

Total leverage can therefore be viewed as the

total impact of the fixed costs in the firm’s

operating and financial structure.

Total Leverage

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Total LeverageDegree of Total Leverage

Scenario 1 Scenario 2 Scenario 3

10% Sales Sales Remain 10% Sales

Decrease Unchanged Increase

Net Sales 630,000$ 700,000$ 770,000$

Less: Variable Costs

(60% of Sales) 378,000 420,000 462,000

Less: Fixed Costs 200,000 200,000 200,000

EBIT 52,000 80,000 108,000

Less: Interest Expense 20,000 20,000 20,000

EBT 32,000 60,000 88,000

Less: Taxes (30%) 9,600 18,000 26,400

Net Income 22,400$ 42,000$ 61,600$

EPS (42,000 shares) 0.53$ 1.00$ 1.47$

EPS Decreases EPS Increases

46.67% 46.67%

Effects of Combined Leverage on the Income Statement

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Interval Estimate of DTL

DTL = % Change in EPS = 46.7% = 4.67 % Change in Sales 10%

Total Leverage

Degree of Total Leverage

In this case, the DTL is greater than 1 which indicates the

presence of both fixed operating and fixed financing

costs. In general, the greater the DTL, the greater the

financial leverage and the greater the financial risk.

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DTL = DOL x DFL

Total Leverage

Degree of Total Leverage

The relationship between the DTL, DOL, and

DFL is illustrated in the following equation:

DTL = 3.50 x 1.33 = 4.6

Applying this to our example at a sales level of

$77, we get:

Which is the same result we obtained using either

the point or interval estimates at that sales level.

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Carbonlite Inc Fiberspeed Corp

Sales volume 10,000 sofas 10,000 sofas

Price $1,000 $1,000

Total Revenue $10,000,000 $10,000,000

Fixed costs per year $5,000,000 $2,000,000

Variable costs per frame

$400 $700

Total cost $9,000,000 $9,000,000

EBIT $1,000,000 $1,000,000

Carbonlite Inc. vs. Fiberspeed Corp.

What if sales volume increases by 10% ?

11,000 frames11,000 frames

$11,000,000$11,000,000

$9,700,000$9,400,000

$1,300,000$1,600,000

The two firms are in the same industry.

Carbonlite’s EBIT increases faster because it has high operating leverage.

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Operating Leverage for Carbonlite and Fiberspeed

Fiberspeed

Carbonlite 

EBIT

Sales

Other things equal, higher operating leverage means that Carbonlite’s beta will be higher

than Fiberspeed’s beta.

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The Effect of Financial Lev. On Beta

Firm 1 Firm 2Assets $100 million $100 millionDebt $0 $50 millionEquity $100 million $50 million

Case #1: Gross Return on Assets Equals 20 PercentEBIT $20 million $20 millionInterest $0 $4 millionCash to equity $20 million $16 millionROE 20 ÷ 100 = 20% 16 ÷ 50 = 32%

Case #2: Gross Return on Assets Equals 5 PercentEBIT $5 million $5 millionInterest $0 $4 millionCash to equity $5 million $1 millionROE 5 ÷ 100 = 5% 1 ÷ 50 = 2%

Financial leverage makes Firm 2’s ROE more volatile, so its beta will be higher .

12-33

Video: Eades

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