For Midterm exam Advanced Financial Planning

Question 1

What is the definition of Return on new invested capital, RONIC? (be careful with the time-stamp of the accounting numbers).

Answer 1

It measures the increase in operating income relative to
additionally invested capital

Question 2

What is the definition of Net Investment.

Answer 2

It is the increase in invested capital from one year to the next

Net Investment = ICt - ICt-1

Question 3

Negative Free cash flow

Answer 3

indicates the firms inability to generate enough cash to support the business.
could also show positive signs that reinvestments are causing accelerated revenue growth.

Question 4

A firm with RONIC<ROIC should not plan to grow, because growth will certainly destroy value. Why/why not?

Answer 4

Calculating ROIC considers four key components: operating income, tax rates, book value, and time. The ROIC formula is net operating profit after tax divided by invested capital. Companies with a steady or improving return on capital are unlikely to put significant amounts of new capital to work. (See slide 13)

Question 5

What is the economic profit?

Answer 5

It can be expressed as the spread between ROIC and the cost of capital, multiplied by the amount of invested capital.

Question 6

How to trade off short-term decline in economic profit against long-term improvement

Answer 6

Need to aggregate multiple years into a single number to compare the different strategies.

Suggestions: Discounted cash flow:
DCF = cashflow / (1+r)^t

Question 7

When do we create more value?

Answer 7

When we can invest at returns above the cost of capital

Question 8

Gordon growth model

Answer 8

The present value of a stream of constantly growing cash flows is given by

DCFvalue = cash flow / (Cost of capital - growth)

Question 9

Invested Capital, IC

Answer 9

Invested capital, IC, is the book value of the company’s operating capital, i.e., the capital that is
necessary to perform the company’s core operations

Question 10

Net Operating Profit Less Adjusted Taxes, NOPLAT

Answer 10

Net operating profit less adjusted taxes is the after-tax operating income (generated by the
firm’s invested capital) that is available to all investors (equityholders and debtholders)

NOPLAT = Revenue - Operating expenses - Adjusted taxes

Question 11

Return on Invested Capital, ROIC

Answer 11

Return on invested capital, ROIC, measures operating earnings relative to invested capital

It tells us how capital intensive the firm’s profit generation is.

Question 12

Return on New Invested Capital, RONIC

Answer 12

Return on new invested capital, RONIC, measures the increase in operating income relative to
additionally invested capital,

Question 13

Free Cash Flow, FCF

Answer 13

Free cash flow, FCF, constitutes the after-tax cash flow available to all investors (debtholders
and equityholders)

FCFt = NOPLATt - Net Investment

Question 14

Investment Rate, IR

Answer 14

A firm’s investment rate is defined as net investment divided by operating profits

Question 15

Investment, Return on Investment and Growth

Answer 15

gt = RONICt x IRt-1
where g is the growth rate of the firm’s NOPLAT

Question 16

Higher growth will generate higher value when:

Answer 16

The return on new invested capital is greater than the cost of capital,

Question 17

Weighted Average Cost of Capital, WACC

Answer 17

Weighted average cost of capital, WACC, is the rate of return that investors expect to earn
from investing in the company and therefore the appropriate discount rate for the free cash
flow.

Question 18

Economic Profit, EP

Answer 18

Economic profit measures the value created by a company in a given period and is defined as
follows:

Economic Profitt = Invested Capital t-1  x (ROICt - WACC)

Question 19

Equivalence of DCF Valuation and Economic Profit Valuation

Answer 19

DCF Value = IC t=0 + Discounted future EP

Question 20

Advantage of EP model over the DCF model

Answer 20

Is that economic profit is a useful measure for understanding a company’s performance in any single year, whereas free cash flow is not

Question 21

You can easily improve free cash flow in a given year at the expense of long-term value creation by

Answer 21

delaying investment.

Question 22

EP Valuation

Answer 22

The present value of future free cash flows can be calculated as the book value of productive assets at the beginning of the valuation period plus the discounted sum of all future economic profit that will be generated by the firm