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Chapter 3•Financial Statements

Balance SheetIncome StatementStatement of Cash Flows

• Accounting income v.s Cash flow•MVA and EVA

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Topics in Chapter

• Income statement• Balance sheet• Statement of cash flows• Accounting income versus cash flow• MVA and EVA

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Income Statement2006 2007

Net Sales 2,850 3,000 Operating costs 2,497 2,616.2 Deprec. 90 100 EBIT 263 283.8 Int. expense 60 88 EBT 203 195.8Taxes (40%) 81.2 78.3Preferred dividends 4 4Net income 117.8 113.5Common dividends 53 57.5Retained earnings 64.8 56

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What happened to sales and net income?

• Sales increased.• Costs increased as expected with sales.• Interest expense increased.

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Balance Sheet: Assets2006 2007

Cash 15 10 Short term investments

65 0

Accounts receivable 315 375Inventories 415 615 Total CA 810 1,000 Net FA 870 1,000 Total assets 1,680 2,000

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Effect of Expansion on Assets• Net fixed assets increased.• AR and inventory increased.• Cash and short-term investments fell.

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Statement of Retained Earnings, 2007

Balance of ret. earnings, 12/31/2006 710

Add: Net income, 2007 113.5

Less: Dividends paid, 2007 (57.5)Balance of ret. earnings, 12/31/2007 766

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Balance Sheet: Liabilities & Equity

2006 2007Accts. payable 30 60Notes payable 60 110 Accruals 130 140 Total CL 220 310 Long-term debt 580 754 Common stock 130 130Ret. earnings 710 766 Total equity 840 896 Total L&E 1,680 2,000

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What effect did the expansion have on liabilities & equity?

• CL increased as creditors and suppliers “financed” part of the expansion.

• Long-term debt increased to help finance the expansion.

• The company didn’t issue any stock.

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Statement of Cash Flows: 2007

Operating ActivitiesNet Income (before preferred div.) 117.

5Adjustments: Depreciation 100 Change in AR (60) Change in inventories (200) Change in AP 30 Change in accruals 10 Net cash provided by ops. (2.5)Cal State East Bay

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Investing Activities Cash used to acquire FA (230) Sale of Short term investments

65

Net cash provided by inv. act. (165)

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Financing Activities Change in notes payable 50 Change in long-term debt 174 Payment of cash dividends (61.5)Net cash provided by fin. act. 162.5

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Summary of Statement of CF

Net cash provided by ops. (2.5)Net cash to acquire FA (165)Net cash provided by fin. act. 162.5Net change in cash (5)Cash at beginning of year 15Cash at end of year 10Cal State East Bay

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What can you conclude from the statement of cash flows?

• Net CF from operations = -$2.5, because of increases in working capital.

• The firm spent $165 on FA. • The firm borrowed and sold some short-term

investments to meet its cash requirements.• Even after borrowing, the cash account fell by

$5.

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What is free cash flow (FCF)? Why is it important?

• FCF is the amount of cash available from operations for distribution to all investors (including stockholders and debtholders) after making the necessary investments to support operations.

• A company’s value depends upon the amount of FCF it can generate.

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•Sales Revenues

•Operating Costs and

Taxes

•Required Investments

in Ops.

•Financing Decisions

•Interest Rates

•Firm Risk •Market Risk

•Free Cash Flows (FCF)

•Weighted Average Cost

of Capital (WACC)

)1()1()1()1( 33

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WACCFCF

WACCFCF

WACCFCF

WACCFCFValue

•Value of the Firm

•Basic Corporate Valuation Model

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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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What are operating current assets?

• Operating current assets are the CA needed to support operations.– Op CA include: cash, inventory, receivables.– Op CA exclude: short-term investments,

because these are not a part of operations.

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What are operating current liabilities?

• Operating current liabilities are the CL resulting as a normal part of operations.– Op CL include: accounts payable and

accruals.– Op CL exclude: notes payable, because this

is a source of financing, not a part of operations.

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What effect did the expansion have on net operating working capital (NOWC)?

NOWC07 = ($10 + $375 + $615)

- ($60 + $140)= $800.

NOWC06 = $585.

= -Operating CA

Operating CLNOWC

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What effect did the expansion have on total net operating capital (also just

called operating capital)?• Operating Capital= NOWC + Net fixed

assets.• Operating Capital 2007 = $800 + $1,000 =

$1,800.• Operating Capital 2006 = 870 + 585=

$1,455.

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Did the expansion create additional net operating profit

after taxes (NOPAT)? NOPAT = EBIT(1 - Tax rate)

NOPAT07 = $283.8(1 - 0.4)

= $170.3.

NOPAT06 = $157.8.

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What was the free cash flow (FCF) for 2007?

FCF = NOPAT - Net investment in operating capital = $170.3 - ($1,800 - $1,455) = $170.3 - $345 = -$174.7.

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Return on Invested Capital (ROIC)

ROIC = NOPAT / operating capital

ROIC07 = $170.3/ $1,800 = 9.46%.

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The firm’s cost of capital is 10%. Did the growth add value?

• No. The ROIC of 9.46% is less than the WACC of 10%. Investors did not get the return they require.

• Note: High growth usually causes negative FCF (due to investment in capital), but that’s ok if ROIC > WACC. For example, Home Depot had high growth, negative FCF, but a high ROIC.

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Economic Value Added (EVA)• WACC is weighted average cost of capital

• EVA = NOPAT- (WACC)(Capital)

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Economic Value Added(WACC = 10% for both years)

EVA = NOPAT- (WACC)(Capital)EVA07 = $170.3- (0.10)($1,800)

= $170.3- $188= -$17.7.

EVA06 = $157.8 - (0.10)($1,455)

= $157.8 - $145.5= $12.3

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Stock Price and Other Data

2006 2007

Stock price $26 $23

# of shares 50 50

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Market Value Added (MVA)• MVA = Market Value of the Firm - Book

Value of the Firm• Market Value = (# shares of stock)(price

per share) + Value of debt• Book Value = Total common equity + Value

of debt

(More…)Cal State East Bay

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MVA (Continued)• If the market value of debt is close to the

book value of debt, then MVA is:

• MVA = Market value of equity – book value of equity

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2007 MVA (Assume market value of debt = book value of debt.)

• Market Value of Equity 2007:– (50)($23.00) = $1,150.

• Book Value of Equity 2007:– $896.

• MVA07 = $1,150 - $896 = $254.

• MVA06 = $1,300 - $840 = $460.

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CHAPTER 12

•Cash Flow Estimation and Risk Analysis

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Free Cash Flow• FCF = NOPAT – Net investment in operating

capital• Gross investment in operating capital= Net

investment in operating capital + Depreciation• Operating cash flow = NOPAT + Depreciation• FCF= Operating cash flow – Gross investment in

operating capital

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Free Cash Flow• FCF=operating cash flows – gross fixed

asset expenditures – (∆ operating current assets – ∆ operating current liabilities)

• FCF= investment outlay cash flow + operating cash flow + NOWC cash flow + salvage cash flow

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Estimating cash flows:

– Relevant cash flows– Working capital treatment– Inflation

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Proposed Project• $200,000 cost + $10,000 shipping +

$30,000 installation.• Economic life = 4 years.• Salvage value = $25,000.• MACRS 3-year class.

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• Annual unit sales = 1,250.• Unit sales price = $200.• Unit costs = $100.• Net operating working capital (NOWC) =

12% of sales.• Tax rate = 40%.• Project cost of capital = 10%.

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Incremental Cash Flow for a Project

• Project’s incremental cash flow is:

Corporate cash flow with the projectMinus

Corporate cash flow without the project.

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Treatment of Financing Costs• Should you subtract interest expense or

dividends when calculating CF? • NO. We discount project cash flows with a cost

of capital that is the rate of return required by all investors (not just debtholders or stockholders), and so we should discount the total amount of cash flow available to all investors.

• They are part of the costs of capital. If we subtracted them from cash flows, we would be double counting capital costs.

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Sunk Costs• Suppose $100,000 had been spent last year to

improve the production line site. Should this cost be included in the analysis?

• NO. This is a sunk cost. Focus on incremental investment and operating cash flows.

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Incremental Costs• Suppose the plant space could be leased out for

$25,000 a year. Would this affect the analysis?• Yes. Accepting the project means we will not

receive the $25,000. This is an opportunity cost and it should be charged to the project.

• A.T. opportunity cost = $25,000 (1 - T) = $15,000 annual cost.

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Externalities• If the new product line would decrease sales of

the firm’s other products by $50,000 per year, would this affect the analysis?

• Yes. The effects on the other projects’ CFs are “externalities”.

• Net CF loss per year on other lines would be a cost to this project.

• Externalities will be positive if new projects are complements to existing assets, negative if substitutes.

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What is the depreciation basis?

Basis = Cost + Shipping + Installation $240,000

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Annual Depreciation Expense (000s)

Year % X (Initial Basis) = Depr.

1 0.33 $240 $79.2

2 0.45 108.0

3 0.15 36.0

4 0.07 16.8

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Annual Sales and Costs

Year 1 Year 2 Year 3 Year 4Units 1250 1250 1250 1250Unit Price

$200 $206 $212.18 $218.55

Unit Cost

$100 $103 $106.09 $109.27

Sales $250,000

$257,500

$265,225

$273,188

Costs $125,000

$128,750

$132,613

$136,588Cal State East Bay

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Why is it important to include inflation when estimating cash

flows?• Nominal r > real r. The cost of capital, r,

includes a premium for inflation.• Nominal CF > real CF. This is because

nominal cash flows incorporate inflation.• If you discount real CF with the higher

nominal r, then your NPV estimate is lower than what it should be.

• Use nominal cash flows and use nominal discount rate.

•Continued…Cal State East Bay

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Operating Cash Flows (Years 1 and 2)

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Year 1Year 2

Sales $250,000$257,500

Costs $125,000$128,750

Depr. $79,200$108,000

EBIT $45,800$20,750

Taxes (40%) $18,320$8,300

NOPAT $27,480$12,450

+ Depr. $79,200$108,000

Net Op. CF $106,680$120,450

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Operating Cash Flows (Years 3 and 4)

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Year 3Year 4

Sales $265,225$273,188

Costs $132,613$136,588

Depr. $36,000$16,800

EBIT $96,612$119,800

Taxes (40%) $38,645$47,920

NOPAT $57,967$71,880

+ Depr. $36,000$16,800

Net Op. CF $93,967$88,680

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Cash Flows due to Investments in Net Operating Working Capital (NOWC)

SalesNOWC

(% of sales)

CF Due toInvestmen

t in NOWC

Year 0 $30,000 -$30,000Year 1 $250,000 $30,900 -$900Year 2 $257,500 $31,827 -$927Year 3 $265,225 $32,783 -$956Year 4 $273,188 $0 $32,783

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Salvage Cash Flow at t = 4 (000s)

Salvage Value $25Book Value 0Gain or loss $25Tax on salvage value

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Net Terminal CF

$15

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What if you terminate a project before the asset is fully

depreciated?• Basis = Original basis - Accum. deprec.• Taxes are based on difference between

sales price and tax basis.• Cash flow from sale = Sale proceeds-

taxes paid.

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Example: If Sold After 3 Years for $25 ($ thousands)

• Original basis = $240.• After 3 years, basis = $16.8 remaining.• Sales price = $25.• Gain or loss = $25 - $16.8 = $8.2.• Tax on sale = 0.4($8.2) = $3.28.• Cash flow = $25 - $3.28 = $21.72.

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Example: If Sold After 3 Years for $10 ($ thousands)

• Original basis = $240.• After 3 years, basis = $16.8 remaining.• Sales price = $10.• Gain or loss = $10 - $16.8 = -$6.8.• Tax on sale = 0.4(-$6.8) = -$2.72.• Cash flow = $10 – (-$2.72) = $12.72.• Sale at a loss provides tax credit, so cash flow is

larger than sales price!

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Net Cash Flows for Years 1-3

0 1 2Init. Cost -

$240,0000 0

Op. CF 0 $106,680 $120,450NOWC CF -$30,000 -$900 -$927

Salvage CF

0 0 0

Net CF -$270,000

$105,780 $119,523Cal State East Bay

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Net Cash Flows for Years 4-53 4

Init. Cost 0 0Op. CF $93,967 $88,680NOWC CF -$956 $32,783Salvage CF 0 $15,000Net CF $93,011 $136,463

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•Enter CFs in CFLO register and I = 10.• NPV = $88,030.• IRR = 23.9%.

•0 •1 •2 •3 •4

•(270,000) •105,780 •119,523 •93,011 •136,463

Project Net CFs on a Time Line

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