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

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)

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) + Depreciation – ΔGFA – ΔNWC 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?