Business Finance Michael Dimond

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 Taxes EBIT(1-t) OCF = Operating Cash Flow NOPAT + Depreciation Expense Why doesn’t this work: NI + Interest + Depreciation Expense NOTE: Operating Cash Flow is not the same as Cash Flow from Operations FCF = Free Cash Flow OCF – 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 Equity FCF – 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 Uses expected performance instead of historical data Used in choosing potential projects or valuing businesses

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 GFA – Δ NCA = FCF 322 – 300 – 0 = 22 322 – 300 – 0 = 22 Net Fixed Assets increased 200, and depreciation was 100, so Δ GFA = 300 How much did current assets change? How much did AP & Accruals change?

OCF → FCF OCF – ΔGFA – ΔNCA = FCF 322 – 300 – 0 = 22 322 – 300 – 0 = 22 Current Assets increased 100, so Δ CA = 100 CLOP (AP + Accruals) was 700 in 2011 and 800 in 2012, so Δ CLOP = 100 We need the Net amount, so we subtract: Δ CA - Δ CLOP = Δ NCA 100 - 100 = 0

FCF: Free Cash Flow (recap) Free Cash Flow: The cash generated which is available to satisfy the needs of lenders and the wants of investors. FCF = OCF – Net Cash Investment in Operating Capital FCF = EBIT(1-t) – ΔGFA – ΔNCA Used in making value-based decisions

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?

Capital Budgeting Decisions 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?

Capital Budgeting Decisions 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? 1 2 3 4 5 1 2 3 4 5 Sell old machine Buy new machine Install new machine Increase NWC needs Reduced Operating Costs Sell “new” machine Reduce NWC needs Proposal:

Relevant Cash Flows What are the cash inflows and outflows? 1 2 3 4 5 1 2 3 4 5 Sell old machine Buy new machine Install new machine Increase NWC needs Reduced Operating Costs Sell “new” machine Reduce NWC needs Proposal:

Initial Investment Sell old machine Buy New 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 Install new machine Increase NWC (Net Working Capital) needs

(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?

Initial Investment Sell old machine Buy New 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

(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?

Initial Investment Sell old machine Buy New 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?

Relevant Cash Flows What are the cash inflows and outflows? 1 2 3 4 5 1 2 3 4 5 Sell old machine Buy new machine Install new machine Increase NWC needs $264,600 Inflow $1,200,000 Outflow $150,000 Outflow $25,000 Outflow _________________ Io = $1,110,400 Outflow Reduced Op. Costs Sell “new” machine Reduce NWC needs Proposal: Reduced Operating Costs

Terminal Value Terminal Value Sell “new” machine after year 5 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 = $1,350k Remember, 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. 1 2 3 4 5 Sell old machine Buy new machine Install new machine Increase NWC needs $264,600 Inflow $1,200,000 Outflow $150,000 Outflow $25,000 Outflow _________________ Io = $1,110,400 Outflow Reduced Op. Costs Sell “new” machine Reduce NWC needs $147,000 Inflow $25,000 Inflow __________________ TV = $172,000 Inflow $350k Proposal: Reduced Operating Costs

Relevant Cash Flows What are the cash inflows and outflows? 1 2 3 4 5 1 2 3 4 5 Sell old machine Buy new machine Install new machine Increase NWC needs $264,600 Inflow $1,200,000 Outflow $150,000 Outflow $25,000 Outflow _________________ Io = $1,110,400 Outflow Reduced Op. Costs Sell “new” machine Reduce NWC needs $147,000 Inflow $25,000 Inflow __________________ TV = $172,000 Inflow Proposal: Reduced Operating Costs

(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?

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. 1 2 3 4 5 Sell old machine Buy new machine Install new machine Increase NWC needs $264,600 Inflow $1,200,000 Outflow $150,000 Outflow $25,000 Outflow _________________ Io = $1,110,400 Outflow Reduced Op. Costs Sell “new” machine Reduce NWC needs $147,000 Inflow $25,000 Inflow __________________ TV = $172,000 Inflow $350k Proposal: Reduced Operating Costs

Relevant Cash Flows Depreciation is a non-cash expense, but it does have an effect on tax expense (therefore depreciation has an effect cash flows).

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?

DCF analysis What is the hurdle rate? 9.0% What/when are the incremental cash flows?

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.