Intro to Projecting Returns Flashcards
First Principle The Investment Decision
Hurdle Rate: The required return on an investment, considering the risk involved and the mix of debt and equity used.
Return: The expected return should account for the magnitude and timing of cash flows, as well as any side effects of the investment.
Usually left side of balance sheet
left hand side BS
First Principle The Financing Decision
Optimal Debt-Equity Mix: Finding the balance of debt and equity that maximizes the firm’s value.
Right Kind of Debt: Selecting debt that aligns with the life span of the assets being financed. Right side of the balance sheet.
Right hand side BS
First Principle The Dividend Decision
Return to Investors: Determining how much to return to investors is based on current assets and future growth opportunities.
Form of Return: Deciding whether to return cash to investors via dividends or buybacks, depending on investor preferences.
Measures of Return- Principles Governing Accounting Earnings Measurement: Accrual Acctg
Show revenues when products and services are
sold or provided, not when they are paid for. Show expenses associated with these revenues rather than cash expenses.
Measures of Return- Principles Governing Accounting Earnings Measurement: Operating Versus Capital Expenditures
Operating Exp: Only expenses associated with creating revenues in the current period should be treated as operating expenses.
Capital Expenditure: Expenses that create benefits over several periods are written off over multiple periods (as depreciation or amortization)
Measures of Return: To get from Acctg Earnings to Cash Flows:
- you have to add back non-cash expenses (like depreciation and or amortization )
- you have to subtract out cash outflows which are not expensed (such as capital expenditures, PPE, net operating working capital)
- you have to make accrual revenues and expenses into cash revenues and expenses (by considering changes in working capital).
The Balance Sheet
Corporate Finance decisions are either investment
decisions or financing decisions
* Investment decisions involve the purchase and sale of
any assets (show up on the left-hand side of the B/S)
* Financing decisions involve the choice of debt and equity
used to fund the accumulation of assets (right-hand side
of the B/S).
Assets = Liabilities + Owners’ Equity
Measuring Return –
The Basic Principles
Use cash flows rather than earnings. You cannot spend
earnings.
* Use “incremental” cash flows relating to the
investment decision, i.e., cash flows that occur as a
consequence of the decision, rather than total cash
flows.
* Use “time weighted” returns, i.e., value cash flows that
occur earlier more than cash flows that occur later.
* The Return Mantra: “Time-weighted, Incremental
Cash Flow Return
The Income Statement
-I/S use (rev recog principle/matching principle)
-While expenses are “matched”, they are not necessarily cash outlays (depreciation/taxes)
-assitional line-item
Additional line-item considerations
* Product costs vs. Period costs
* Variable costs vs. Fixed costs
Cash flow from assets
equation 1: cash flow to creditors (bondholders) + cash flow to stockholders (owners)
equation2: operating cash flow - net capital spending (CAPEX) - change in NOWC
operating cash flow = EBIT + Depreciation - Taxes
NCP = Ending Net Fixed Assets - Beginning Net Fixed Assets + Depreciation
Equation 3: (EBIT + Depreciation - Taxes) - (End net fixed assets - beg net fixed assets + depreciation)
Operating cash flow
EBIT + Depreciation - Taxes
Net Capital Spending
End net fixed assets - beg net fixed assets + depreciation
cash flow to stockholders (owners)
dividends paid - net new equity raised
cash flow to creditors (bondholders)
interest paid - net new borrowing
free cash flows
Free Cash Flow = EBIT(1-t) + Depreciation – Capex – ΔNOWC
EBIT (Earnings Before Interest and Taxes): Represents the operating profit of the company before accounting for interest and taxes.
(1 - t): Multiplies EBIT by (1 - t) to account for taxes, where t is the tax rate. This gives the after-tax operating income.
Depreciation: Added back because it’s a non-cash charge that reduces EBIT but doesn’t affect cash flow.
Capex (Capital Expenditures): Represents the funds used by a company to acquire or upgrade physical assets such as property, industrial buildings, or equipment. Subtracted because these are cash outflows.
ΔNOWC (Change in Net Operating Working Capital): Represents the change in the company’s working capital. An increase in NOWC implies a cash outflow (and is subtracted), while a decrease implies a cash inflow (and is added).
measuring return: Front: Why use cash flows rather than earnings in return measurement?
You cannot spend earnings; cash flows represent actual available resources for investment and spending.
measuring return: What are “incremental” cash flows in the context of investment decisions?
Incremental cash flows are those that occur as a direct result of the investment decision, excluding cash flows that would occur regardless of the decision.
measuring return: Why are “time-weighted” returns important in return measurement?
Time-weighted returns value cash flows that occur earlier more than those that occur later, due to the time value of money.
measuring return: What is the “Return Mantra”?
The Return Mantra is “Time-weighted, Incremental Cash Flow Return,” emphasizing the importance of timing and the decision-related cash flows in return measurement.
measuring return: cash flow vs earning
use cash flows rather than earnings
The balance sheet investment decisions
involve the purchase and sale of any asset (left hand side BS)
The balance sheet financing decisions
involve the choice of debt and equity used to fund the accumulation of assets (right hand side BS)
Balance sheet left side: What are current assets?
Current assets include cash and other assets typically converted to cash within 12 months, such as inventory and accounts receivable.
Balance Sheet Left Side: What are fixed assets?
Fixed assets have a relatively long life and are usually classified as tangible (e.g., property, plant, and equipment) or intangible (e.g., patents, trademarks).
Balance Sheet: What is the comparison between BS and MV
The accounting balance sheet value may sometimes deviate significantly from the market value, with potential drastic differences.
Balance Sheet Right Side: What is Shareholder Equity
Shareholders’ equity is the difference between total assets and total liabilities and includes items such as stock accounts, paid-in capital, treasury stock, and retained earnings.
NOWC
NOWC = CurrentAssets ∗ − CurrentLiabilities ∗∗
Current Assets: Includes assets that can be converted into cash within 12 months (like accounts receivable, inventory), but excludes excess cash, which is considered a capital structure decision, not an operating asset.
Current Liabilities: Includes obligations due within 12 months (like accounts payable), but excludes any interest-bearing debt components, such as notes payable and current portions of long-term debt, since these are financing decisions rather than operational ones.
The Income Statement: Revenue Recognition Principle
Revenues are recognized when earned, not necessarily when cash is received.
The Income Statement: Matching Principle
Expenses are recognized in the same period as the revenues they help generate, regardless of when the cash outflow occurs.
The Income Statement: Adjust for Noncash Items:
While expenses are “matched” to revenues, they may not involve actual cash outflows.
Examples:
Depreciation: Allocating the cost of an asset over its useful life.
Taxes: Accrued expenses based on income earned but paid at different times.
The Income Statement: Product vs Period Cost
Product Costs: Directly tied to production (e.g., raw materials, labor), recorded as inventory until sold.
Period Costs: Expenses not tied to production (e.g., SG&A expenses), expensed in the period they occur.
The Income Statement: Fixed vs Variable Cost
Variable Costs: Fluctuate with production (e.g., raw materials, direct labor).
Fixed Costs: Remain constant regardless of production level (e.g., rent, salaries).
sources and uses of cash: assets increase
use of cash (purchase inventory, new property),
sources and uses of cash: liabilities decrease
use of cash (paid off some debt, paid down your A/P, etc)
sources and uses of cash: assets decrease
source of cash (customers pay down your AR , sells a machine)
sources and uses of cash: liabilities increase
sources of cash (raised additional debt financing, you’re stringing out your vendors longer)
Free Cash Flows
EBIT (1-t) + Depreciation - Capex - Change NOWC
Use or Source of Cash: Assets Increase
use of cash
Use or Source of Cash: Liabilities Decrease
use of cash
Use or Source of Cash: Assets Decrease
source of cash
churn =
of customer base left
net new equity raised
cash new shares - cash used to buy its own shares (common stock change)
net new borrowing
new debt issued - debt repayments (total debt)
