Accounting for Financial Management Chapter 6 Accounting for Financial Management

Topics covered Income statement Balance sheet Statement of cash flows Free cash flow ROIC, MVA and EVA

Balance Sheets Figure 6-1 Cash equivalent vs. short-term investments Common equity (net worth) total asset – liability – preferred stocks

Income Statement Figure 6-2 EBITDA

Statement of Cash Flows Figure 6-4

Cash flows from operating activities FI 3300 - Corporate Finance Leng Ling Cash flows from operating activities IS means Income Statement Net income + Depreciation Decrease in any asset account related to IS - Increase in any asset account related to IS Decrease in any liability account related to IS Increase in any liability account related to IS = Net cash flow from operating activities

Cash flows from operating activities Asset accounts related: Accounts receivable Inventories Liability accounts related: Accounts payable Accruals

Cash flows from investing activities Buying or selling productive assets (plant & equipment) Buying or selling financial securities that expire after 1 year (e.g., stock of other companies, bonds)

Useful equation when compute cash flows from investing activities FI 3300 - Corporate Finance Leng Ling Useful equation when compute cash flows from investing activities Change in gross fixed assets = change in net fixed assets + depreciation

Cash flows from financing activities Loans from creditors (long-term, short-term) Repayment of principal Sale or repurchase of stock (common or preferred) from firm’s equity holders Payment of dividends

Net Cash Flow Net cash flow= Net income + Depreciation and amortization

What is free cash flow (FCF)? 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 on the amount of FCF it can generate.

Calculating Free Cash Flow in 5 Easy Steps Earning before interest and taxes Operating current assets X (1 − Tax rate) − Operating current liabilities Net operating profit after taxes Net operating working capital Step 3 Net operating working capital + Operating long-term assets Total net operating capital Step 5 Figure 2-1 in FM13 Step 4 Net operating profit after taxes Total net operating capital this year − Net investment in operating capital − Total net operating capital last year Net investment in operating capital Free cash flow

Step 1: Net Operating Profit after Taxes (NOPAT) NOPAT = EBIT(1 - Tax rate) NOPAT15 = $500(1 - 0.4) = $300

Step 2: Net Operating Working Capital (NOWC) = - Operating CA CL NOWC NOWC15 = ($50 + $500 + $1000) - ($200 + $300) = $1,050 NOWC14 = $790

Operating current assets Operating current assets are the CA needed to support operations. Op CA include: cash, inventory, account receivables. Op CA exclude: short-term investments, because these are not a part of operations.

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.

Step 3:Total net operating capital (operating capital) Operating Capital= NOWC + Net fixed assets Operating Capital 2015 = $1050 + $2000 = $3,050 Operating Capital 2014 = $2,490

Step 4 and step 5 (6-8) FCF = NOPAT - Net investment in operating capital = $300 - ($3050 - $2490) = $300 - $560 = -$260 (6-9) FCF = ($300+$200)-$500-($1050-$790) = $-260

Five uses of FCF 1. Pay interest on debt. 2. Pay back principal on debt. 3. Pay dividends. 4. Buy back stock (repurchase). 5. Buy nonoperating assets (e.g., marketable securities, investments in other companies, etc.)

Uses of FCF After-tax interest payment = $72 Reduction (increase) in debt = −$350 Payment of dividends = $58 Repurchase (Issue) stock = $0 Purch. (Sale) of ST investments = −$40 Total uses of FCF = −$260

Return on Invested Capital (ROIC) ROIC = NOPAT / operating capital ROIC15 = $300 / $3050 = 9.84%. 9.84% <11% (WACC)

Did the growth add value? No. The ROIC is less than the WACC. 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.

Economic Value Added (EVA) EVA = NOPAT- (WACC)(Operating Capital) =(Operating Capital)(ROIC) - (WACC)(Operating Capital) = (Operating Capital)(ROIC-WACC)

Economic Value Added EVA = NOPAT- (WACC)(Operating Capital) = $300 - $335.5 = -$35.5

Market Value Added (MVA) MVA = Market Value of the Firm - Book Value of the Firm Market Value = (# shares of stock)(price per share) + Market Value of debt Book Value = Total common equity + Book Value of debt

MVA (Continued) If the market value of debt is close to the book value of debt, then: MVA = Market value of equity – Book value of equity

2015 MVA for MicroDrive Market Value of Equity 2015: (50)($27) = $1350. Book Value of Equity 2015: $1470. MVA15 = $1350 - $1470 = -$120

MVA vs. EVA EVA is the measure typically used to evaluate the manager. EVA shows the value added during a given year, while MVA reflects performance over the company’s entire life. EVA can be applied to individual divisions, whereas MVA applied to the entire firm.

Assignment Review slides of Chapter 2 from FINC3131 Chapter 6 problems: 3,4,5,6,10,12,14,15.