Financial ManagementLecture No. 4

Modifying Accounting Data for Managerial Decision

Modifying Accounting Data for Managerial Decision

Financial Statements are presented in Annual Report, Share holders and managers use these statements, some others stakeholders are also interest in these statement. Stakeholders need some modified information for corporate decision. Financial analyst combine stock prices and accounting data to make the statement more useful.

1st step in modifying Account is categories of Assets

Two Categories of Assets:1. Operating Assets:

• Assets necessary to operate Business. Operating Assets are further divided in two categories

1. Operating Current Assets 2. Long term operating Assets.

2. Non Operating Assets1. Non Operating assets refers to assets above the

level of operating requirement, such short term investment, land held by company, and cash above the level of requirement.

Operating Assets and Operating Capital

Operating Current Assets:

Operating Current assets are the current assets that are used to support operations, such as cash, inventory and account receivable. They do not include short term investment.

Operating current Liabilities are the current liabilities that occur as n natural consequence of operations, such as account payable and accruals. They do not include notes payable or any other short term debt that charge interest.

Investor supplied Capital

Net Operating Working CapitalNOWC is the difference between operating

current assets and operating current liabilities. Thus, it is the working capital acquired with investor-supplied fund.

NOWC=Operating current assets – Operating current liabilities

NOWC= (Cash+A/R+Inventories)- (Account payable +Accruals)

NOWC=(10+375+615)-(60+140)

NOWC=800 million

Operating Long Term Assets

OLTA are the long-term assets used to support operations, such as net plant and equipment. They do not include any long term investment that pay interest or dividend.

Total Operating assets (or Capital) or operating assets/Capital, is the sum of net operating capital and operating long-term assets. It is the total amount of capital needed to run the business.

Total operating Capital

TOC= (Net Operating working capital)+ Operating Long term assets

TOC= 800 + 1000= 1800Increase in MicroDrive Networking capital NOWC(last year)= ( 15+315+415)-(30+130)NOWC = 385 last year current 800Total operating capital = 385+870 = 1455 Last year current 1800Net investment in operating Asset = 1800-1455 = 345Sale did not increase with same ratio so cash is used in

working capital.

Net operating profit After tax

NOPAT is net operating profit after taxes if the company had no debt and no investment in non-operating assets. Because it exclude the effect of financial decision, it is better measure of operating performance than its net income.

NOPAT = EBIT(1-t)

NOPAT = 283.8(1-0.4) = 170.3

Free Cash Flow

FCF is the amount of cash flow remaining after a company makes the assets investment necessary to support operations. In other words, FCF is the amount of cash flow available for distribution to investors, sot he value of a company is directly related to is ability to generate free cash flow it is defined as

FCF = NOPAT – Investment in operating Capital

FCF = 170.3-345 = 174.7

The uses of FCFFCF is the amount of cash available for

distribution to all investors, including both shareholders and debt holders. There are five good uses for FCF.

1. Pay interest to debt holders,

2. Repay debt-holders, that is pay off some debt.

3. Pay dividends to share holders.

4. Repurchase stock from shareholders

5. Buy marketable securities or other non-operating assets.

FCF and corporate value

FCF is the cash available for distribution to investors. Therefore, the value of a firm is primarily dependent on its expected future Free cash flow.

Return on invested capital

ROIC is the one way to determined whether growth is profitable or not. If the ROIC exceeds the rate of return required by investors then a negative FCF caused high growth is nothing to worry about.

If ROIC is greater than the rate of return investors require than the firm is adding value. This require rate of return is found as Weighed average cost of capital. WACC

ROIC = NOPAT/Operating assets.

MVA and EVAThese are two more tools other than traditional

and modifying accounting data. Financial analyst develop these two methods to examine the maximization of the firms. These are MVA and EVA.

Market value added

MVA represents the difference between the total market value of a firm and the total amount of investors-supplied capital. If the market values of debt and preferred stock equal their values as reported on the financial statements, then MVA is the difference between the market value of a firm’s stock and the amount of equity its shareholders have supplies.

Market Value Added

=Market value of stock –Equity capital supplied by shareholders

Or

=(share outstanding x stock price)- Total common equity

Economic value added EVA

EVA is the difference between after tax operating profit and the total dollar cost of capital, including the cost of equity capital. EVA is an estimate of the value created by management during the year, and it differs substantially from accounting profit because no charge for the use of equity cpaital is reflected in accounting profit.

EVA

EVA= Net operating profit after tax –After tax dollar cost of capital used to support operations

or

=EBIT(1-corporate tax rate)-(Operating capital )(WACC)

Or

=(operating Capital)(ROIC-WACC)

EVA Concepts

• In order to generate positive EVA, a firm has to more than just cover operating costs. It must also provide a return to those who have provided the firm with capital.

• EVA takes into account the total cost of capital, which includes the cost of equity.

MVA Calculation (Million Dollars) (Million Dollars)

Price per share 23 26

Number of share 50 50

Market value of equity 1150 1300

Book value of equity 896 840

MVA= Market value –Book value 254 460

EVA Calculation

EBIT 283.8 263

Tax rate 40% 40%

NOPAT= (EBIT(1-tax)) 170.3 157.8

Total investor supplied operating capital 1800 1455

After tax cost of capital WACC % 11% 10.8

Dollar cost of capital = Capital (WACC) 198 157.1

EVA= NOPAT – Capital cost (27.7) 0.70

ROIC = NOPAT/operating capital 9.46% 10.85%

ROIC – Cost of capital = ROIC -WACC (1.54%) 0.05%

EVA =Operating capital (ROIC-WACC) (27.7) 0.7

MVA and EVA for Micro Drive 2001 2000

Depreciation

Depreciation is important tools to reduce income tax. The larger the depreciation, the lower the taxable income and thus the lower the tax bill, hence the higher the cash flow from the operation.