Cash Flow And Leverage(12-13) Professor Trainor

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Cash Flow Versus Accounting Profit Capital budgeting concerned with cash flow, not accounting profit. To evaluate a capital investment, we must know: Incremental cash outflows of the investment (marginal cost of investment), and Incremental cash inflows of the investment (marginal benefit of investment). The timing and magnitude of cash flows and accounting profits can differ dramatically.

Cash Flow and Non-Tax Expenses Accountants charge depreciation to spread a fixed asset’s costs over time to match its benefits. Capital budgeting analysis focuses on cash inflows and outflows when they occur. Non-cash expenses affect cash flow through their impact on taxes: Compute after-tax net income and add depreciation back, or Ignore depreciation expense but add back its tax savings.

Two Methods of Handling Depreciation to Compute Cash Flow $6,000 Net income $16,000 Cash flow = NI + deprec (4,000) Taxes (40%) $10,000 Pre-tax income (10,000) Depreciation $20,000 Gross profits Cost of goods $30,000 Sales Adding non-cash expenses back to after-tax earnings $4,000 Depreciation tax savings Cash Flow $12,000 Aft-tax income (8,000) Find after-tax profits, add back non-cash charge tax savings Simplest and most common technique: Add depreciation back in. Assume a firm purchases a fixed asset today for $30,000 Plans to depreciate over 3 years using straight-line method Firm will produce 10,000 units/year Costs $1/unit Sells for $3/unit Firm pays taxes at a 40% marginal rate

Depreciation Many countries allow one depreciation method for tax purposes and another for reporting purposes. Accelerated depreciation methods (such as MACRS) increase the present value of an investment’s tax benefits. Relative to MACRS, straight-line depreciation results in higher reported earnings early in an investment’s life. For capital budgeting analysis, the depreciation method for tax purposes matters most.

The Initial Investment Initial cash flows: Cash outflow to acquire/install fixed assets Cash inflow from selling old equipment Cash inflow (outflow) if selling old equipment below (above) tax basis generates tax savings (liability) An example.... Tax rate = 40% New equipment costs $10 million, $0.5 million to install Old equipment fully depreciated, sold for $1 million Initial investment: outflow of $10.5 million, and after-tax inflow of $0.60 million from selling the old equipment

Working Capital Expenditures Many capital investments require additions to working capital. Net working capital (NWC) = current assets – current liabilities. Increase in NWC is a cash outflow; decrease a cash inflow. An example… Operate booth from November 1 to January 31 Order $15,000 calendars on credit, delivery by Nov 1 Must pay suppliers $5,000/month, beginning Dec 1 Expect to sell 30% of inventory (for cash) in Nov; 60% in Dec; 10% in Jan Always want to have $500 cash on hand

Working Capital for Calendar Sales Booth (4,000) +500 NA Monthly  in WC (3,000) 1,000 500 Net WC 5,000 10,000 15,000 Accts payable 1,500 10,500 Inventory $0 $500 Cash Feb 1 Jan 1 Dec 1 Nov 1 Oct 1 +3,000 ($5,000) $0 Payments ($500) Net cash flow $1,500 [10%] $9,000 [60%] $4,500 [30%] Reduction in inventory Jan 1 to Feb 1 Dec 1 to Jan 1 Nov 1 to Dec 1 Oct 1 to Nov 1 Payments and inventory +$4,000 ($3,000)

Construct cash-flow forecasts for 5 to 10 years Terminal Value Terminal value is used when evaluating an investment with indefinite life-span: Construct cash-flow forecasts for 5 to 10 years Forecasts more than 5 to 10 years have high margin of error; use terminal value instead. Terminal value is intended to reflect the value of a project at a given future point in time. Large value relative to all the other cash flows of the project.

JDS Uniphase cash flow projections for acquisition of SDL Inc. Terminal Value Different ways to calculate terminal values: Use final year cash flow projections and assume that all future cash flow grow at a constant rate; Multiply final cash flow estimate by a market multiple, or Use investment’s book value or liquidation value. $3.25 Billion $2.5 Billion $1.75 Billion $1.0 Billion $0.5 Billion Year 5 Year 4 Year 3 Year 2 Year 1 JDS Uniphase cash flow projections for acquisition of SDL Inc.

Terminal Value of SDL Acquisition Assume that cash flow continues to grow at 5% per year (g = 5%, r = 10%, cash flow for year 6 is $3.41 billion): Terminal value is $68.2 billion; value of entire project is: $42.4 billion of total $48.7 billion from terminal value Using price-to-cash-flow ratio of 20 for companies in the same industry as SDL to compute terminal value Terminal Value = $3.25 x 20 = $65 billion Caveat : market multiples fluctuate over time

Incremental Cash Flow Incremental cash flows versus sunk costs: Capital budgeting analysis should include only incremental costs. An example… Norman Paul’s current salary is $60,000 per year and he expects it to increase at 5% each year. Norm pays taxes at flat rate of 35%. Sunk costs: $1,000 for GMAT course and $2,000 for visiting various programs Room and board expenses are not incremental to the decision to go back to school

What about Norm’s opportunity cost? Incremental Cash Flow At end of two years assume that Norm receives a salary offer of $90,000, which increases at 8% per year Expected tuition, fees and textbook expenses for next two years while studying MBA: $35,000 If Norm worked at his current job for two years, his salary would have increased to $66,150: Yr 3 net cash inflow: $90,000 - $66,150 = $23,850 After-tax inflow: $23,850 x (1-0.35) = $15,503 Yr 4 cash inflow: MBA has substantial positive NPV value if 30 yr analysis period What about Norm’s opportunity cost?

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Can a firm accept all investment projects with positive NPV? Capital Rationing Can a firm accept all investment projects with positive NPV? Reasons why a company would not accept all projects: Limited availability of skilled personnel to be involved with all the projects; Financing may not be available for all projects. Companies are reluctant to issue new shares to finance new projects because of the negative signal this action may convey to the market.

Operating Leverage

Degree of Operating Leverage The degree of operating leverage (DOL) measures the sensitivity of changes in EBIT to changes in Sales. A company’s DOL can be calculated in two different ways: One calculation will give you a point estimate, the other will yield an interval estimate of DOL. Only companies that use fixed costs in the production process will experience operating leverage.

Degree of Operating Leverage

Degree of Operating Leverage Interval Estimate of DOL DOL = % Change in EBIT = 35% = 3.50 % Change in Sales 10% Because of the presence of fixed costs in the firm’s production process, a 10% increase in Sales will result in a 35% increase in EBIT. Note that in the absence of operating leverage (if Fixed Costs were zero), the DOL would equal 1 and a 10% increase in Sales would result in a 10% increase in EBIT.

Financial Leverage Financial leverage results from the presence of fixed financial costs in the firm’s income stream. Financial leverage can therefore be defined as the potential use of fixed financial costs to magnify the effects of changes in EBIT on the firm’s EPS. The two fixed financial costs most commonly found on the firm’s income statement are (1) interest on debt and (2) preferred stock dividends.

Financial Leverage

Degree of Financial Leverage The degree of financial leverage (DFL) measures the sensitivity of changes in EPS to changes in EBIT. Like the DOL, DFL can be calculated in two different ways: One calculation will give you a point estimate, the other will yield an interval estimate of DFL. Only companies that use debt or other forms of fixed cost financing (like preferred stock) will experience financial leverage.

Degree of Financial Leverage

Degree of Financial Leverage Interval Estimate of DFL DFL = % Change in EPS = 46.67% = 1.33 % Change in EBIT 35.00% In this case, the DFL is greater than 1 which indicates the presence of debt financing. In general, the greater the DFL, the greater the financial leverage and the greater the financial risk.

Total Leverage Total leverage results from the combined effect of using fixed costs, both operating and financial, to magnify the effect of changes in sales on the firm’s earnings per share. Total leverage can therefore be viewed as the total impact of the fixed costs in the firm’s operating and financial structure.

Degree of Total Leverage

Degree of Total Leverage Interval Estimate of DTL DTL = % Change in EPS = 46.7% = 4.67 % Change in Sales 10% In this case, the DTL is greater than 1 which indicates the presence of both fixed operating and fixed financing costs. In general, the greater the DTL, the greater the financial leverage and the greater the financial risk.

Degree of Total Leverage The relationship between the DTL, DOL, and DFL is illustrated in the following equation: DTL = DOL x DFL Applying this to our example at a sales level of $77, we get: DTL = 3.50 x 1.33 = 4.6 Which is the same result we obtained using either the point or interval estimates at that sales level.

Carbonlite Inc. vs. Fiberspeed Corp. The two firms are in the same industry. 11,000 frames Carbonlite Inc Fiberspeed Corp Sales volume 10,000 sofas Price $1,000 Total Revenue $10,000,000 Fixed costs per year $5,000,000 $2,000,000 Variable costs per frame $400 $700 Total cost $9,000,000 EBIT $1,000,000 $11,000,000 $9,700,000 $9,400,000 $1,300,000 $1,600,000 What if sales volume increases by 10% ? Carbonlite’s EBIT increases faster because it has high operating leverage.

Operating Leverage for Carbonlite and Fiberspeed EBIT Carbonlite   Fiberspeed Sales Other things equal, higher operating leverage means that Carbonlite’s beta will be higher than Fiberspeed’s beta.

The Effect of Financial Lev. On Beta Firm 1 Firm 2 Assets $100 million Debt $0 $50 million Equity Case #1: Gross Return on Assets Equals 20 Percent EBIT $20 million Interest $4 million Cash to equity $16 million ROE 20 ÷ 100 = 20% 16 ÷ 50 = 32% Case #2: Gross Return on Assets Equals 5 Percent $5 million $1 million 5 ÷ 100 = 5% 1 ÷ 50 = 2% Financial leverage makes Firm 2’s ROE more volatile, so its beta will be higher .

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