Chapter 5 Flashcards
Changes in operating activities
A section on the cash flow statement that describes the changes in WC. An increase in AR on the CFS (a decrease on the b/s) is a source of cash. An increase of inventory on the CFS (a decrease on the b/s) is a source of cash. An increase in accounts payable (a decrease on the b/s) is a use of cash.
Accounts receivable turnover ratio
Net credit sales ÷ avg. accounts receivable
- This ratio provides good insight into whether a decline in accounts receivable is because customers are paying their credit charges quicker OR because business is slowing. Oftentimes, this ratio is compared to an industry benchmark.
- If this ratio increases, it shows the firm is collecting cash quicker, whereas a decrease shows the firm is collecting cash slower.
Average accounts receivable
(Opening accounts receivable balance + closing accounts receivable balance) ÷ 2
- This ratio provides good insight into whether a decline in accounts receivable is because customers are paying their credit charges quicker OR because business is slowing.
Inventory turnover ratio
COGS ÷ Avg. inventory
- Useful to determine if the buildup in invetory is a result of a slowdown in sales, or is the buildup because of additional inventory purchases in order to keep pace w/ demand.
- Oftentimes, this ratio is compared to an industry benchmark.
Average inventory
(Operating inventory + closing inventory) ÷ 2
- Useful to determine if the buildup in invetory is a result of a slowdown in sales, or is the buildup because of additional inventory purchases in order to keep pace w/ demand.
- Oftentimes, this ratio is compared to an industry benchmark.
Accounts payable turnover
COGS ÷ Avg. accounts payable
- A decrease in this ratio is positive.
Avg. accounts payable
(Opening payables + closing payables) ÷ 2
Asset turnover ratio
Net sales ÷ Avg. assets
- Higher ratio is positive
Average assets
(Assets BOP + Assets EOP) ÷ 2
Net CF formula
CFO - change in WC + CFI - CFF
FCFF formula:
FCFF = EBIT * (1 - T) + D&A - CAPEX - net change in WC
In many cases, NOPAT as used instead of EBIT * (1 - T)
NOPAT formula
Net income + interest expense + nonrecurring costs + tax paid on investment and interest income - investing and interest income - tax shield from interest expense.
Operating profit/EBIT calculation
Net sales - operating expense
True or false: EBITDA is a good representative of CF?
False, EBITDA is a profitability metric that eliminates the effects of financing and accounting decisions.
Return on invested capital (ROIC)
NOPAT ÷ invested capital
Invested capial definition
Total assets - non-interest-bearing current liabilities - excess cash
Match the following metrics w/ the appropriate industry comparison:
1. P/B
2. P/FFO
3. Normalized, relative P/E
4. P/S
5. Earnings yield
6. EV/EBITDA
7. EV/Sales
8. PEG
a. companies w/ negative earnings
b. Companies w/ high P/E ratios
c. Basic industry, Cap intensive
d. Financial services companies
e. Cyclical companies
f. Retail companies
g. Start ups
h. REITs
1 - d
2 - h
3- e
4 - a/g
5 - a
6 - c
7 - f
8 - b
Firm A has 2 business segments:
- It’s mining business contributes 90% of the firm’s earnings
- It’s financial services division generates much lower revenues, but a significantly higher profit margin.
What’s the best approach to valuing Firm A:
- A sum of the parts method should be used if the divisions have different growth rates
- A sum of the parts method should be used if different valuation methods are used.
- A DCF method is preferable since each remaiing segment is profitable
- EV/EBITDA should be used due to the significance of the company’s industrial base
B.
Which of the folowing statements is NOT true in a rising rate environment:
A. There’s a negative impact on DCF
B. WACC will decline
C. The PV of pension liabilities will decline
D. The Rf will be higher
B
Long-term debt-to-capitalization ratio
Long-term debt ÷ (equity + long-term debt)
Interest coverage ratio
EBIT ÷ interest expense
Rate of economic value added
The ROIC-to-WACC spread (ROIC - WACC) can be used show if a company is generating economic value.
Formula: ROIC - WACC
ex: If firm A has ROIC of 12% and WACC of 8%, 12% - 8% = 4% - 4 cents of value is created for each dollar invested. If firm B has a ROIC of 4% and a WACC of 8%, 4% - 8% = -4% - 4 cents of value is destroyed per dollar invested.
- If the spread is positive, returns exceed cost of capital.
Residual income
The amount of earnings that exceeds the investors’ required return. The ROIC-to-WACC spread can also be used to calculate residual income.
Formula: When leveraged: RI = ROIC-to-WACC * FCFF
OR
(ROIC - WACC) * invested capital
- Residual income goes one step further than the ROIC-to-WACC spread by estimating the amount of economic value added, rather than just the rate.
- Residual income is advantageous when the teminal value is difficult to estimate and/or dividends are inconsistent and when operating CF is negative.
Economic value added (EVA) formula
NOPAT - (WACC * invested capital)
OR
(ROIC - WACC) * invested capital
Market value added
PV of EVA
- Therefore, enterprise value can be caluclated by calculating the expected EVA for a series of years, finding their PV and summing their results.
ROIC-to-WACC ratio
ROIC ÷ WACC
ROIC ÷ WACC = EV ÷ invested capital
- A ratio > 1 indicates the firm is creating value. A ratio < 1 indicates the company is destorying value.
- The ratio can be used to estimate the EV of a company: EV = invested capital (ROIC ÷ WACC).
EPS calculation
(NI - preferred dividends) ÷ Avg. # of CS outstanding
Dividend yield %
Annual dividend ÷ Current market price of CS
How to calculate ROIC-to-WACC if a company acquires more debt
- Find the projected net sales (new total debt ÷ last year’s debt as a % of sales)
- Find the projected NOPAT (#1 * last year’s NOPAT as a % of sales)
- ROIC = #2 * invested capital (make sure to include the new debt)
- # 3 ÷ new WACC
True or false: An additional debt offering would likely significantly decrease the ROIC-to-WACC ratio?
False, it would likely significantly increase the ratio.
Invested capital formula
TA - non-interest-bearing CL - excess cash
True or false: If a proposed acquisition lowers the ROIC-to-WACC ratio, it is a good idea?
False, it’s not a good idea since it will be destroying economic value.
