Capitalized Cash Flow Approach Flashcards
When to use Capitalized Cash Flow Approach
The business is capital intensive or accounting depreciation is not representative of the annual capital reinvestment requirements.
Major differences between Maintainable Earnings approach and Cash Flow approach
CF approach allows the Company to deduct capital cost allowance (depreciation) from taxable income to reduce payable taxes, which holds value for the business. Under Maintainable earnings, deprecation approximates the amount being spent on assets annually, so they offset each other and no additional calculations are required. However, if capital spending is expected to outpace P&L depreciation, then the cash-flow-tax-savings need to be considered under the cash flow method.
Cash Flow method also deals with issues that P&L deprecation doesn’t address. For example, if a company has much older assets, depreciation may indicate much lower capital spending than reality. Or the Company may be entering an abnormal period of increased spending which needs to be reflected in the value as well.
What is Sustaining Capital Reinvestment?
Cash left over from operations is often required for reinvestment to keep the company operation at a certain level. These funds, known as sustaining capital, must be removed before capitalization of the cashflows because the funds have already been earmarked for reinvestment and will not be available for use by the investor on a discretionary basis.
The annual capital reinvestment expenditures that the business makes will have an associated stream of tax savings that will accrue in the future as a result of claiming capital cost allowance, expressed in terms of today’s dollars. Therefore, the present value of the tax savings resulting from the available capital cost allowance associated with the sustaining capital additions (i.e., the tax shield) is deducted from the gross amount of sustaining capital reinvestment.
What is the Sustaining Capital Reinvestment formula for new sustaining capital investments?
1) First Year Sustaining Capital Investment, which includes the half year rule for new capital investments.
UCC (newly invested capital) x Tax Rate x CCA rate (deprecation rate) / (Rate of Return + CCA rate)
X
((1 + (0.5 x Rate of Return)) / (1 + Rate of Return)
What is Incremental Net Trade Working Capital?
If the Company is experiencing growth in revenues and cash flows (from real revenue growth, not from margin increases) then the Company may require additional net working capital to support those operations, which will impact the cash inflows and outflows of the business.
However, if growth is significant, valuators should consider using a DCF approach rather that a cash flow approach. However, it may be necessary in a CF valuation (not typical).
Steps in calculating Capitalized Cash Flow Method
1) Determine what method is to be used and why.
- Capital investment to maintain CURRENT business operations does not equate the deprecaiton of the company.
- the company is capital intensive.
2) Find EBITDA
- If unlevered, interest is to be removed. If levered, interested will be added back in the adjustments.
- deprecation is a non-cash item and therefore is to be removed.
- Income tax is to be removed and will be reapplied to normalized cash flows.
3) Adjustments
- complete adjusting entries to find adjusted cash flows
4) If levered, calculate leverage adjustment to find the appropriate interest expense and add back. If unlevered, continue to next step.
5) Reapply income taxes.
6) Find Normalized range and articulate why the specific range has been selected
- if growing company, more weight placed on recent years.
- if fluctuating, a simple average may be used over full period.
- etc.
7) Reduce normailzed range by annual sustaining capital reinvestment.
8) Add back First Year tax sheild (longer formula)
9) Determine capitalization rate (WACC - G)
10) apply Cap Rate to normalized cash flows to find capitalized cash flows.
11) add Present Value of Existing Tax Shield (short formula using different UCC)
12) Add back leverage adjustment if levered approach
13) Reduce by debt if unlevered approach
14) add back redundant assets.
What is the sustaining capital formula for existing UCC balances?
This is determining the present value of tax savings on existing capital assets already owned by the company. They are taxed in full without the half rule and take place after capitalization of cash flows happens.
UCC (previously invested capital) x Tax Rate x CCA rate (deprecation rate) / (Rate of Return + CCA rate)
