Chapter 2: Financial Statements, Cash Flow, and Taxes

Question 1

Net cash flow

Answer 1

= net income - non-cash revenues + non-cash expenses

where net income = net income available for distribution to common shareholders

(may essentially be net income + depreciation and amortization)

Question 2

Free cash flows

Answer 2

the stream of cash flows generated by operating activities that investors expect to receive now and in the future

amount of cash from operations available for distribution to the investors after making the necessary investments to support operations

Question 3

Calculating free cash flow by how it is used

Answer 3

FCF = cash flow available for distribution to all the company’s investors after the company has made all investments necessary to sustain ongoing operations

Question 4

calculating free cash flow by how it is generated

Answer 4

FCF = after-tax operating profit minus the amount of new expenditures necessary to sustain the business

Question 5

5 steps to calculating free cash flow

Answer 5

1) calculate net operating profit after taxes
2) calculate net operating working capital
3) use net operating working capital to calculate total net operating capital
4) use total net operating capital from current and previous year to calculate net investment in operating capital for year
5) calculate FCF by subtracting net investment in operating capital from net operating profit after taxes

Question 6

Net operating profit after taxes

Answer 6

= (earnings before interest and taxes) x (1-tax rate)

NOPAT

amount of profit a company would generate if it had no debt and held no financial assets

Question 7

Net operating working capital

Answer 7

= operating current assets - operating current liabilities

NOWC

the working capital acquired with investor supported funds
(because each dollar of current liabilities is a dollar the company does not have to raise from investors)

(not same as net working capital which is assets - liabilities)

if NOWC = 0 all operations are funded with current liabilities

used to measure efficiency of fund use

Question 8

Total net operating capital

Answer 8

= net operating working capital + operating long-term assets

aka net operating capital or operating capital

change in net operating capital from one year to another shows money invested in the company

= net amount of investor supplied operating capital

but net operating capital can be applied to individual divisions and investor supplied capital can only be applied to the entire company

Question 9

Net investment in operating capital

Answer 9

net investment in operating capital made during the given year

= total net operating capital this year - total net operating capital last year

Question 10

Calculation of free cash flow

Answer 10

= Net operating profit after taxes - net investment in operating capital

Question 11

Operating current assets

Answer 11

Short term assets normally used in a company’s operating activities (essential to the ongoing operations)

does not include short term investments

Question 12

Non operating assets

Answer 12

excluded from operating current assets, not not occur as a natural consequence of operating activities

short-term marketable securities

if an asset pays interest it is probably not an operating asset

Question 13

operating current liabilities

Answer 13

short term liabilities that arise in the normal course of operations

(short term financing liabilities probably not operating liabilities. if it charges interest it is probably not an operating liability - so notes payable are financing, not operations)

Question 14

investor-supplied capital

Answer 14

total amount of short-term debt, long-term debt, preferred stock, and total common equity shown on the balance sheet

= the amount of financing that the investors have provided a company

Question 15

total investor supplied operating capital

Answer 15

= total investor-supplied capital - short-term investments

should be the same as total net operating capital from the year

but net operating capital can be applied to individual divisions and investor supplied capital can only be applied to the entire company

Question 16

alternate calculation of free cash flow

Answer 16

= (EBIT*(1-T) + Depreciation) - (gross investment in fixed assets) - (investment in net operating working capital)

Question 17

“good” uses of FCF

Answer 17

• pay interest to debtholders (after-tax interest expense)
• repay debtholders
• pay dividends to shareholders
• repurchase stock from shareholders
• buy short term investments or other nonoperating assets

Question 18

“Negative” uses of free cash flow

Answer 18

• issuing new debt
• issuing new stock
• selling short term investments / nonoperating assets

Question 19

After tax interest payment

Answer 19

Interest expense * (1 - tax rate)

Question 20

net debt repayment (issuance)

Answer 20

= amount of debt at the beginning of the year - amount at the end of the year

positive = paid down some debt
negative = borrowed additional funds

Question 21

Return on invested capital

Answer 21

how much NOPAT is generated by each dollar of operating capital

= NOPAT / operating capital

measure of how well the company is operating - excludes the impact of financial leverage

a real measure of profitability - shows returns from investments exceed cost of funds

compare to WACC to determine if ROIC is high enough to add value

Question 22

Market value added

Answer 22

the difference between the market value of the firm’s stock and the cumulative amount of equity capital that was supplied by shareholders

= market value of stock - equity capital supplied by shareholders

= ((shares outstanding * stock price)+ market value of debt) - (book value of equity + bv of debt)

measures the effects of managerial actions since the inception of the company

Question 23

alternate MVA calculation

Answer 23

= total market value - total investor supplied capital
= (market value of stock + market value of debt) - total investor supplied capital

investor supplied capital generally = equity + debt + preferred stock

Question 24

Economic Value added

Answer 24

EVA

= NOPAT - (total net operating capital * WACC)

a measure of managerial effectiveness in a given year, the extent to which the firm has increased shareholder value

= Net operating profit after taxes - after tax dollar cost of capital used to support operations

estimate of businesses “true” profit for the year. the residual income that remains after the cost of ALL capital has been deducted (all capital = lending and equity, so after shareholders have received their return as well)

Question 25

Cost of equity capital

Answer 25

because the shareholders give up the opportunity to invest and earn returns elsewhere the cost is an opportunity cost

Question 26

Calculating EVA from ROIC

Answer 26

= (total net operating capital) * (ROIC - WACC)

as long as ROIC exceeds WACC growth increases value. If WACC exceeds ROIC growth may actually reduce value by costing too much

Question 27

what does it mean if NOWC and fixed assets are both 0

Answer 27

essentially running a business without capital

rate of return will be higher because it is all/ almost all return

valuation of business increases because the capital is not being depended upon to run operations

Question 28

how to drive NOWC to 0

Answer 28

• inventory efficiency / JIT inventory
• not selling on credit

Question 29

capital efficiency

Answer 29

Deploying less capital to produce the same output

Question 30

EBIT

Answer 30

Earnings before interest and taxes

Question 31

Negative free cash flow

Answer 31

means no money left after operations and investment

not inherently bad as long as investments are worthwhile

Question 32

Cost of capital

Answer 32

Rate at which company can get money. depends on percentage of capital from equity vs the percentage of capital from debt
- what the shareholders are looking for in return (depends on risk)
- cost of borrowing less tax savings

Question 33

Cost of capital

Answer 33

Rate at which company can get money. depends on percentage of capital from equity vs the percentage of capital from debt
- what the shareholders are looking for in return (depends on risk) (return is built into WACC)
- cost of borrowing less tax savings

Question 34

How to use weighted average cost of capital in business decisions

Answer 34

If investments offer a return equal to or higher than the cost of capital everyone is getting what they want or more

if return is lower than weighted average cost of capital it is not a good decision

Question 35

0 NPV transaction

Answer 35

Transaction where the return is exactly equal to the weighted average cost of capital

still getting return for investors because return is built into WACC

Question 36

Why is net income not a good measure of profit for financial measurement

Answer 36

Because does not consider cost of capital, only cost of borrowing

Question 37

EVA based compensation schemes

Answer 37

require transparency from company

used to incentivize sustainable positive EVA

bonus mapped to EVA is deposited into an account which the employee can only draw some portion of. if EVA is negative the following year the company can take back some of previous bons