business finance ba303 ♦ spring 2013 michael dimond

Business FinanceBA303 ♦ Spring 2013

Michael Dimond

Michael DimondSchool of Business Administration

Module F: Cash Flows & Valuation

• Big module• Start HW early so you have time to digest the topics

• I recommend you stop when you get to the big, comprehensive problems. We’ll be working on these in class, which will make the HW easier.


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?


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


Cash Flows

• NOPAT = Net Operating Profit After TaxesEBIT(1-t)

• OCF = Operating Cash FlowNOPAT + Depreciation Expense

NI + Interest + Depreciation Expense• NOTE: Operating Cash Flow is not the same as Cash Flow from Operations

• FCF = Free Cash FlowOCF – 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 EquityFCF – Net Cash Flow to Debt

• Free Cash Flow to for Equity: The cash generated which is available to satisfy the wants of investors.


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


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


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.


Depreciation

• What is depreciation?• Straightline vs MACRS

• Why do we adjust for depreciation when computing OCF?• What about other non-cash expenses?


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


Operating Cash Flow (OCF)

• From the income statement• EBIT x (1-t) + Depreciation = OCF• 370 x (1-0.4) + 100 = 322


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)


OCF → FCF

• OCF – Δ NFA – Δ NCA = FCF• 322 – 300 – 0 = 22

• Fixed Assets increased200, and depreciation was 100, so Δ NFA = 300

• How much did current assets change?

• How much did AP & Accruals change?


OCF → FCF

• OCF – Δ NFA – Δ NCA = FCF• 322 – 300 – 0 = 22

• Current Assets increased 100, so Δ CA = 100

• CLOP (AP + Accruals) was700 in 2011 and800 in 2012, so Δ CLOP = 100

• We need the Net amount,so we subtract:Δ CA - Δ CLOP = Δ NCA 100 - 100 = 0


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:

• Is life ever that simple?

9% Hurdle RateYEAR 0 1 2 3 4 5

Initial Investment (1,110,400) Incremental CF 257,200 344,400 274,200 258,800 274,800 Terminal Value 172,000 Total CF (1,110,400) 257,200 344,400 274,200 258,800 446,800 PV (1,110,400.0000) 235,963.3028 289,874.5897 211,732.7102 183,340.4446 290,389.3434 NPV (Sum of PVs, less Initial Investment) 100,900.3907 IRR 12.24%PBP 3.91



• More realistically, it will be something like this:• (based on P11-29)

• Holliday Manufacturing is considering the replacement of an existing machine. The new machine costs $1.2 million and requires installation costs of $150,000. The existing machine can be sold currently for $185,000 before taxes. The old machine is 2 years old, cost $800,000 when purchased, and has a $384,000 book value and a remaining useful life of 5 years. It was being depreciated under MACRS using a 5-year recovery period, so it has the final 4 years of depreciation remaining. If it is held for 5 more years, the machine’s market value at the end of year 5 will be zero. Over its 5-year life, the new machine should reduce operating costs by $350,000 per year, and will be depreciated under MACRS using a 5-year recovery period. The new machine can be sold for $200,000 net of removal and cleanup costs at the end of 5 years. A $25,000 increase in net working capital will be required to support operations if the new machine is acquired. The firm has adequate operations against which to deduct any losses experienced on the sale of the existing machine. The firm has a 9% cost of capital and is subject to a 40% tax rate. Should they accept or reject the proposal to replace the machine?



• Step 1:


Break a complicated problem into smaller pieces• To make an objective capital budget 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.• Scenario

• Invest in replacement machine (Proposal) or stick with old machine (BAU)

• Relevant Cash Flows• Initial investment (net cost to acquire and install the new machine)• Annual net benefit • Terminal value (What the new machine will be worth at the end of the timeline)

• Incremental Cash Flows (ie, what changes because of the decision?)• Compare the relevant CFs to the Business-As-Usual (BAU) CFs

• DCF Analysis (the easy part)• Discount the incremental cash flows at the hurdle rate

• Objective Decision• Positive NPV, IRR > Hurdle Rate, Acceptable Payback Period


Scenario

• How long is the timeline?• What happens, and when?

0 1 2 3 4 5

Sell old machineBuy new machineInstall new machineIncrease NWC needs

Reduced Op. CostsSell “new” machineReduce NWC needs

Proposal:

ReducedOperating

Costs

ReducedOperating

Costs

ReducedOperating

Costs

ReducedOperating

Costs


Relevant Cash Flows

• What are the cash inflows and outflows?

0 1 2 3 4 5



Proposal:

ReducedOperating

Costs

ReducedOperating

Costs

ReducedOperating

Costs

ReducedOperating

Costs


Initial Investment

• Sell old machine• $185,000 before taxes

• Gain or loss on sale of asset?• Proceeds – Book Value = Gain or (Loss)• What was the book value? $384,000• 185k – 384k = (199k)• Tax Rate x Gain or (Loss) = Tax Effect• 40% x ($199,000) = ($79,600) :. The company will pay less tax because of the loss.

• After-tax Proceeds = $185,000 – ($79,600) = $264,600

• Buy New Machine• $1,200,000

• Install new machine• $150,000

• Increase NWC (Net Working Capital) needs• $25,000


• (based on P11-29)

• Holliday Manufacturing is considering the replacement of an existing machine. The new machine costs $1.2 million and requires installation costs of $150,000. The existing machine can be sold currently for $185,000 before taxes. The old machine is 2 years old, cost $800,000 when purchased, and has a $384,000 book value and a remaining useful life of 5 years. It was being depreciated under MACRS using a 5-year recovery period, so it has the final 4 years of depreciation remaining. If it is held for 5 more years, the machine’s market value at the end of year 5 will be zero. Over its 5-year life, the new machine should reduce operating costs by $350,000 per year, and will be depreciated under MACRS using a 5-year recovery period. The new machine can be sold for $200,000 net of removal and cleanup costs at the end of 5 years. A $25,000 increase in net working capital will be required to support operations if the new machine is acquired. The firm has adequate operations against which to deduct any losses experienced on the sale of the existing machine. The firm has a 9% cost of capital and is subject to a 40% tax rate. Should they accept or reject the proposal to replace the machine?


Terminal Value

• Terminal Value• Terminal value is the is the remaining value a project has after the

intermediate cash flows have all happened.

• Terminal Value is sometimes called residual value. On a capital project, it might be called salvage value.

• Sell “new” machine after year 5• $200,000 before taxes

• Gain or loss on sale of asset?• Proceeds – Book Value = Gain or (Loss)• What was the book value? $67,500• 200k – 67.5k = 132.5k Gain• Tax Rate x Gain or (Loss) = Tax Effect• 40% x $132,500 = $53,000 :. The company will pay more tax because of the gain.

• After-tax Proceeds = $200,000 – $53,000 = $147,000

• Decrease NWC needs• $25,000


Book Value of “new” machine after 5 years• Cost = $1,350kRemember, this includes cost + installation

• D1 = 270 k (20%)• D2 = 432 k (32%)• D3 = 256.5k (19%)• D4 = 162 k (12%)• D5 = 162 k (12%)

• BV = $67.5k


Relevant Cash Flows

• What are the cash inflows and outflows?

• Is that all?• We also need to consider the effect which depreciation has on tax expense.

0 1 2 3 4 5


$264,600 Inflow$1,200,000 Outflow

$150,000 Outflow$25,000 Outflow

_________________Io = $1,110,400

Outflow


$147,000 Inflow$25,000 Inflow

__________________TV = $172,000

Inflow

$350k

Proposal:

ReducedOperating

Costs

$350k

ReducedOperating

Costs

$350k

ReducedOperating

Costs

$350k

ReducedOperating

Costs

$350k


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 MachineYEAR 0 1 2 3 4 5

Reduction in Operating Cost 350,000 350,000 350,000 350,000 350,000 Depreciation 270,000 432,000 256,500 162,000 162,000 Net Profit before Tax 80,000 (82,000) 93,500 188,000 188,000 Tax (@40%) 32,000 (32,800) 37,400 75,200 75,200 Net Profit After Tax 48,000 (49,200) 56,100 112,800 112,800 Operating Cash Flow 318,000 382,800 312,600 274,800 274,800


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?

• What is the difference between BAU and the proposal cash flows?

CF for Old MachineYEAR 0 1 2 3 4 5

Depreciation 152,000 96,000 96,000 40,000 - Net Profit before Tax (152,000) (96,000) (96,000) (40,000) - Tax (@40%) (60,800) (38,400) (38,400) (16,000) - Net Profit After Tax (91,200) (57,600) (57,600) (24,000) - Operating Cash Flow 60,800 38,400 38,400 16,000 -

Incremental CFYEAR 0 1 2 3 4 5

New Machine CF 318,000 382,800 312,600 274,800 274,800 Old Machine CF 60,800 38,400 38,400 16,000 - Incremental CF (Difference) 257,200 344,400 274,200 258,800 274,800


DCF analysis

• What is the hurdle rate?• 9.0%

• What/when are the incremental cash flows?9% Hurdle Rate

YEAR 0 1 2 3 4 5Initial Investment (1,110,400) Incremental CF 257,200 344,400 274,200 258,800 274,800 Terminal Value 172,000 Total CF (1,110,400) 257,200 344,400 274,200 258,800 446,800 PV (1,110,400.0000) 235,963.3028 289,874.5897 211,732.7102 183,340.4446 290,389.3434 NPV (Sum of PVs, less Initial Investment) 100,900.3907 IRR 12.24%PBP 3.91


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 RateYEAR 0 1 2 3 4 5

Initial Investment (1,110,400) Incremental CF 257,200 344,400 274,200 258,800 274,800 Terminal Value 172,000 Total CF (1,110,400) 257,200 344,400 274,200 258,800 446,800 PV (1,110,400.0000) 235,963.3028 289,874.5897 211,732.7102 183,340.4446 290,389.3434 NPV (Sum of PVs, less Initial Investment) 100,900.3907 IRR 12.24%PBP 3.91


What else can we do with valuation?

• The decision is not always, “should we do this or not.” Sometimes the decision is “which alternative should we choose?” For example:• Should we lease or buy an asset?

• Should we make a component or buy a component?

• Sometimes the reason we value something is for investment purposes• What is this stock worth, and why?

• Should we buy this stock? Should we sell? Should we wait?


Lease vs Buy Decision – Lessee’s POV

• To make an objective lease-vs-buy decision, you need to compute the Net Advantage to Leasing (NAL).• The Net Advantage to Leasing is the cost of ownership minus the cost of

leasing

• Cost of ownership is the PV of the purchase scenario

• Cost of leasing is the PV of the leasing scenario• NAL = PVown – PVlease


Lease vs Buy Decision – Lessee’s POV

• Example: 2-year Asset Lease vs Buy DecisionYear 0 Year 1 Year 2

Cost of OwningEquipment cost (100.000)$ Loan amount 100.000$ Interest expense (10.000)$ (10.000)$ Tax savings from interest 4.000$ 4.000$ Principal repayment (100.000)$ Tax savings from depreciation 20.000$ 20.000$

Net cash flow -$ 14.000$ (86.000)$ PV @6% (63.332)$ Cost of ownership 63.332$

Cost of LeasingLease payment (55.000)$ (55.000)$ Tax savings from lease 22.000$ 22.000$

Net cash flow -$ (33.000)$ (33.000)$ PV @ 6% (60.502)$ Cost of leasing 60.502$

Cost of ownership 63.332$ Cost of leasing 60.502$

NAL 2.830$


Make vs Buy Decision


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

• Module G: Financial Statement Analysis

business finance ba303 ♦ spring 2013 michael dimond

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