1. Business Finance
Michael Dimond

2. 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?

3. 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

4. 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.

5. 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

6. 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

7. 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.

8. Depreciation What is depreciation? Straightline vs MACRS
Why do we adjust for depreciation when computing OCF?
What about other non-cash expenses?

9. 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

11. Operating Cash Flow (OCF)
From the income statement
EBIT x (1-t) Depreciation = OCF
370 x (1-0.4) = 322

13. 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)

14. OCF → FCF OCF – Δ GFA – Δ NCA = FCF 322 – 300 – 0 = 22
322 – – = 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?

15. OCF → FCF OCF – ΔGFA – ΔNCA = FCF 322 – 300 – 0 = 22
322 – – = 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 = 0

16. 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

18. 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?

19. 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?

20. Capital Budgeting Decisions
Step 1:

21. 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

22. Scenario How long is the timeline? What happens, and when? 1 2 3 4 51 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:

23. Relevant Cash Flows What are the cash inflows and outflows? 1 2 3 4 51 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:

24. 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

25. (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?

26. 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

27. (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?

28. 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

29. (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?

30. Relevant Cash Flows What are the cash inflows and outflows? 1 2 3 4 51 2 3 4 5
Sell old machine
Buy new machine
Install new machine
Increase NWC needs
$264, 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

31. 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

32. Book Value of “new” machine after 5 years
Cost = $1,350k
Remember, this includes cost + installation
D1 = k (20%)
D2 = k (32%)
D3 = k (19%)
D4 = k (12%)
D5 = k (12%)
BV = $67.5k

33. 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, 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

34. Relevant Cash Flows What are the cash inflows and outflows? 1 2 3 4 51 2 3 4 5
Sell old machine
Buy new machine
Install new machine
Increase NWC needs
$264, 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

35. (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?

36. 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, 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

37. 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).

38. 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?

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

40. 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.