1. Cash Flow And Leverage(12-13)
Professor Trainor

2. Video: Nickel
Smart Finance

3. 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.

4. 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.

5. 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

6. 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.

7. 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

8. 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

9. 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)

10. 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.

11. 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.

12. 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

13. 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

14. 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?

15. Video: Rajan
Smart Finance

16. 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.

17. Operating Leverage

18. 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.

19. Degree of Operating Leverage

20. Degree of Operating Leverage Interval Estimate of DOL
DOL = % Change in EBIT = 35% = 3.50
% Change in Sales %
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.

21. 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.

22. Financial Leverage

23. 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.

24. Degree of Financial Leverage

25. Degree of Financial Leverage Interval Estimate of DFL
DFL = % Change in EPS = % = 1.33
% Change in EBIT %
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.

26. 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.

27. Degree of Total Leverage

28. Degree of Total Leverage Interval Estimate of DTL
DTL = % Change in EPS = % = 4.67
% Change in Sales %
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.

29. 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 = x = 4.6
Which is the same result we obtained using either the point or interval estimates at that sales level.

30. 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.

31. 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.

32. 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 .

33. Video: Eades
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