1. Cash Accounting, Accrual Accounting, and Discounted Cash Flow Analysis
Chapter 4
Cash Accounting, Accrual Accounting, and Discounted Cash Flow Analysis

2. Link to pervious chapter
Cashing Accounting, Accrual Accounting, and Discounted Cash Flow Analysis
Link to pervious chapter
Chapter 3 outlined the process of fundamental analysis and depicted valuation as a matter of forecasting future financial statements
This chapter introduces discounted cash flow valuation, a method that involves forecasting future cash flow statements. The chapter also shows how cash flows differ from accrual earnings in the income statement, and how ignoring accruals in discounted cash flow valuation can cause problems.
This Chapter
What is the
dividend discount model?
Does it work?
What is the discounted cash flow model?
Does it work?
What is the difference between cash accounting and accrual accounting?
What form of accounting best captures value added in operations: cash accounting or accrual accounting?
Chapter 5 and 6 together lay out valuation methods that forecast accrual accounting income statements and balance sheets.
Link to next chapter
This web page provides further explanation and additional examples of discounted cash flow analysis, cash accounting, and accrual accounting.
Link to web page

3. What you will learn from this Chapter
How the dividend discount model works (or does not work)
What is meant by cash flow from operations
What is meant by cash used in investing activities
What is meant by free cash flow
How discounted cash flow valuation works
Problems that arise in applying cash flow valuation
Why free cash flow may not measure value added in operations
Why free cash flow is a liquidation concept
How discounted cash flow valuation involves cash accounting for operating activities
Why “cash flow from operations” reported in U.S. financial statements does not measure operating cash flows correctly
Why “cash flows in investing activities” reported in U.S. financial statements does not measure cash investment in operations correctly
How accrual accounting for operations differs from cash accounting for operations
The difference between earnings and cash flow from operations
The difference between earnings and free cash flow
How accruals and the accounting for investment affect the balance sheet as well as the income statement
Why analysts forecast earnings rather than cash flows
How a valuation model is a model of accounting for the future
How reverse engineering works as an analysis tool
What a “simple valuation” is

4. A Reminder: Valuation Models for Going ConcernsCF 1 2 3 4 5
A Firm d 1 2 3 4 5
Dividend
Flow
TVT T
d T
Equity
The terminal value, TVT is the price payoff, PT when the share is sold
Valuation issues :
The forecast target: dividends, cash flow, earnings?
The time horizon: T = 5, 10, ?
The terminal value
The discount rate

5. The Dividend Discount Model: Targeting Dividends
DDM:
Problems: How far does one project?
Does
provide a good estimate of VE0?
(i) Dividend policy can be arbitrary and not linked to value added.
(ii) The firm can borrow to pay dividends; this does not create value
(iii) Think of a firm that “pays no dividends”
The dividend irrelevancy concept
The dividend conundrum:
Equity value is based on future dividends, but forecasting dividends over finite horizons does not give an indication of this value
Conclusion: Focus on creation of wealth rather than distribution of wealth.

6. Terminal Values for the DDM
A. Capitalize expected terminal dividends
B. Capitalize expected terminal dividends with growth
Will it work?

7. Some Math: The Value of a Perpetuity and a Perpetuity with Growth
A perpetuity is a constant stream that continues without end. A constant stream is sometimes referred to as an annuity, so a perpetuity is an annuity that continues forever. To value that stream, one capitalizes the constant amount expected. If the dividend expected next year is expected to be a perpetuity, the value of the dividend stream is
Value of a perpetual dividend stream =
The Value of a Perpetuity with Growth
If an amount is forecasted to grow at a constant rate, its value can be calculated by capitalizing the amount at the required return adjusted for the growth rate:
Value of a dividend growing at a constant rate =

8. Dividend Discount Analysis: Advantages and Disadvantages

9. Cash Flows for a Firm C1 C2 C3 C4 I1 I2 I3 I4 C1-I1 C2-I2 C3-I3 C4-I4
Free cash flow is cash flow from operations that results from investments
minus cash used to make investments.
Cash flow from
operations (inflows)
Cash investment
(outflows)
Free cash flow
Time, t C1 C2 C3 C4 I1 I2 I3 I4
C1-I1
C2-I2
C3-I3
C4-I4 C5 I5
C5-I5 1 2 4 3 5

10. The Discounted Cash Flow (DCF) Model

11. The Continuing Value for the DCF Model
A. Capitalize terminal free cash flow
B. Capitalize terminal free cash flow with growth

12. DCF Valuation: The Coca-Cola Company
In millions of dollars except per-share numbers. Required return for the firm is 9%
Cash from operations , , , , ,929
Cash investments , ,
Free cash flow , , , , ,311
Discount rate (1.09)t
Present value of free cash flow , , , , ,452
Total present value to ,367
Continuing Value (CV) * ,414
Present value of CV ,611
Enterprise value ,978
Book value of net debt ,435
Value of equity ,543
Shares outstanding ,472
Value per share $40.67
*CV = 5,311 x = 139,414
Present value of CV = 139,414 = 90,611
1.5386

13. Will DCF Valuation Always Work?
A Firm with Negative Free Cash Flows: General Electric Company
In millions of dollars, except per share amounts.
Cash from operations 30,009 39,398 34,848 36,102 36,484
Cash investments 37,699 40,308 61,227 21,843 38,414
Free cash flow (7,690) (910) (26,379) 14,259 (1,930)
Earnings 12,735 13,684 14,118 15,002 16,593
Earnings per share (eps)
Dividends per share (dps)

14. Reverse Engineering: What Forecasts are Implied by the Current Market Price?
Reverse engineer as follows:
Can Coke maintain this growth rate?

15. Simple Valuations
Simple valuations use very short forecasts horizons, and isolate more speculative, long-term forecasts. Accordingly, they anchor on “what we know” or are relatively sure about.
A simple DCF for Coca-Cola, 2000

16. Reverse Engineering a Simple Valuation: Coca-Cola
Applying the simple model to reverse engineer Coke’s stock price,

17. The DCF Model: Will it work for Wal-Mart Stores?
Walt-Mart Stores, Inc.
(Fiscal years ending January 31. Amounts in millions of dollars, except per-share data)
1988
1989
1990
1991
1992
1993
1994
1995
1996
Cash from operations
536
828
968
1,422
1,553
1,540
2,573
3,410
2,993
Cash investments
627
541
894
1,526
2,150
3,5 06
4,486
3,792
3,332
Free cash flow
(91)
287 74
(104)
(597)
(1,966)
(1,913)
(382)
(339)
Dividends per share
0.03
0.04
0.06
0.07
0.09
0.11
0.13
0.17
0.20
Price per share 6⅞ 8½
10⅝
16½ 27
32½
26½
25⅞
24⅜

18. Why Free Cash Flow is not a Value-Added Concept
Cash flow from operations (value added) is reduced by investments (which also add value): investments are treated as value losses
Value received is not matched against value surrendered to generate value
A firm reduces free cash flow by investing and increases free cash flow by reducing investments:
free cash flow is partially a liquidation concept
Note: analysts forecast earnings, not cash flows

19. Discounted Cash Flow Analysis: Advantages and Disadvantages

20. Partial Statement of Cash Flows: Dell Computer

21. Reported Cash Flow from Operations
Reported cash flows from operations in U.S.
cash flow statements is after interest:
Cash Flow from Operations = Reported Cash Flow from Operations + After-tax Net Interest Payments
After-tax Net Interest = Net Interest x (1 - tax rate)
Net interest = Interest payments – Interest receipts
Reported cash flow from operations is sometimes
referred to as levered cash flow from operations

22. Reported Cash Flow in Investing Activities
Reported cash investments include net investments in interest bearing financial assets (excess cash):
Cash investment in operations = reported cash flow from investing net investment in
interest-bearing securities

23. Calculating Free Cash Flow: Dell Computer, 2002
Reported cash flow from operations 3,797
Interest payments
Interest income* (314)
Net interest payments (283)
Taxes (35%) †
Net interest payments after tax (65%) (184)
Cash flow from operations 3,613
Reported cash used in investing activities 2,260
Purchases of interesting-bearing securities 5,382
Sales of interest-bearing securities (3,425) 1,957
Cash investment in operations
Free cash flow 3,310
*Interest payments are given as supplemental data to the statement of cash flows, but interest
receipts usually are not. Interest income (from the income statement) is used instead; this
includes accruals but is usually close to the cash interest received.
†Dell’s statutory tax rate (for federal and state taxes) is 35 percent, as indicated in the financial
statement footnotes.

24. Forecasting Free Cash Flows
It is difficult to forecast free cash flows without forecasting earnings. First forecast earnings and then make adjustments to convert earnings to cash flow from operations. Follow the following steps:
(i) Forecast earnings available to common
(ii) Forecast accruals (the difference between earnings and cash flow from operations in the cash flow statement)
(iii) Calculate levered cash flow from operations (Step (i) -
Step (ii))
(iv) Calculate unlevered cash flow from operations by adding after-tax net interest
(v) Forecast cash investments in operations
(vi) Calculate forecasted free cash flow, C - I (Step (iv) -
Step (v))

25. Forecasting Free Cash Flow: Dell Computer
2000
2001
2002
Earnings
1,666
2,177
1,246
Accrual adjustment
2,260
2,018
2,551
Levered cash flows from
operations
3,926
4,195
3,797
Interest payments 34 49 31
Interest receipts
(158)
(305)
(314 )
Net interest payments
(124)
(256)
(283)
Tax at 35% 43
(81) 9
(166) 99
(184)
Cash flow from operations
3,845
4,029
3,613
Cash investment in operations
(401
(482)
(303)
Free cash flow
3,444
3,547
3,310

26. Features of the Income Statement
1. Dividends don’t affect income
2. Investment doesn’t affect income
3. There is a matching of
Value added (revenues)
Value lost (expenses)
Net value added (net income)
4. Accruals adjust cash flows
Revenue Accruals
Value added that is not cash flow
Adjustments to cash flows that are not value added
Expense Accruals
Value decreases that are not cash flows
Adjustments to cash outflows that are not value decreases

27. The Income Statement: Dell Computer

28. The Revenue Calculation
Revenue = Cash receipts from sales
+ New sales on credit
 Cash received for previous periods' sales
 Estimated sales returns and rebates
 Deferred revenue for cash received in
advance of sale
+ Revenue previously deferred

29. The Expense Calculation
Expense = Cash paid for expenses
+ Amounts incurred in generating revenue but not yet paid
 Cash paid for generating revenues in future
periods
+ Amounts paid in the past for generating revenues in the current period

30. Earnings and Cash Flows
Earnings = [C - I] - i + I + accruals
= C - i + accruals
The earnings calculation adds back investments and puts
them back in the balance sheet. It also adds accruals.

31. Earnings and Cash Flows: Wal-Mart Stores

32. Accruals, Investments and the Balance Sheet
Accruals and investments are put in the balance sheet
Shareholders’ equity = Cash + Other Assets - Liabilities
Earnings
Cash from Operations
Accruals
Free cash flow
Cash from Operations
Investments

33. The Balance Sheet: Dell Computer

34. The articulation of the financial statements through the recording of cash flows and accruals
Net cash flows from all activities increases cash in the balance sheet
Cash from operations increases net income and shareholders’ equity
Cash investments increase other assets
Cash from debt financing increases liabilities
Cash from equity financing increases shareholders’ equity
Accruals increase net income, shareholders’ equity, assets and liabilities