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

10. 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)

11. 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

13. 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?