Pre-work Flashcards
Key decisions under Corporate FInance
- Capital investment strategy and valuation (how much capital, what to invest in)
- FInancial strategy & capital structure (how funds should be raised to maximise value of business to shareholders)
- Distribution strategy (how funds should be distributed to shareholders and in what form)
- FInancial management (Managing CFs to match requirements of investment with requirements of financiers)
- Risk management ( managing financial risk to enhance value and achieve organisation objectives)
Managers of Financial vs Real assets (differences)
- FA: tradeable with transparent prices. Market makers provide liquidity. RA: balance sheet comprises mainly illiquid assets
- FA: investors can invest in part of an issue. RA: risk usually concentrated
- FA: cashflows are contractual. RA: underlying CFs non contractual
- FA: Diversification aids risk reduction. RA: diversification creates negligible value
- FA: Generally able to statistically measure risk. RA: limited ability to measure most risks due to limited observations, linkages and causal relationships
Cash Flow from Operating Activities (Core Business)
- Inflows
- Outflows
Inflows: - cash collected from customers - interest and dividends received - sale proceeds from trading activities (WATCH: accountants often put interest under Operating)
Outflows
- Cash paid to employees and suppliers
- Cash paid for other expenses
- taxes paid
Cashflow from Investing Activities (Long lived assets)
- Inflows
- Outflows
Inflows
- sales proceeds from fixed assets
- sale proceeds from debt and equity investments
- principal received from loans made to others
Outflows
- acquisition of fixed assets
- acquisition of debt and equity investments
- loans made to others
Cashflow from financing activities (debt & equity)
- inflows
- outflows
Inflows
- proceeds from issuance of debt
- proceeds from issuing stock
Outflows
- repayment of debt principal
- repurchase of shares
- dividends paid to shareholders
Net Cash flow =
Net cash flow = CFO + CFI + CFF = Change in Cash
2 ways to calculate cashflows poo and farts
- Direct (extract data direct from cash account)
2. Indirect (Use NPAT as a starting point and add back non cash adjustments (eg depreciation and working capital)
Accounts receivable at end of period = ?
Cash collections = ?
Net operating working capital = ?
Accounts receivable at end of period = Acc Rec @ start + revenue during the period - cash collections during period
Cash collections = Revenue during period + Acc Rec (start) - Acc Rec (end)
Net operating working capital = Inventories + Acc Rec - Acc Payable
(note increases in net working cap absorb cash while decreases will release cash)
interest expense: converting from financial statement version to value oriented version:
- interest expense is often included in CFO rather than CFF under accounting stds. This mixes up operating and finance flows
- therefore move it from operating to finance by ADDING BACK AFTER TAX INTEREST EXPENSE (interest expense x (1-t)) and transfer it to FINANCE
- after tax net interest = net interest expense x (1-t)
working capital: why exclude cashflow?
working capital = CA - CL
- cash is excluded because mmt in value of cash & cash equiv is what we are trying to explain
- ST debt and the current portion of LT debt are excluded - these are interest bearing debt, therefore financing rather than operating items
Provisions:
- need to adjust provisions to calculate cashflow
- created via non cash expenses in income statement
- add back provisions to income.
- provisions result in a non cash gain in income statement
Advantages of using cashflows for valuations rather than profits: (4)
Advantages of valuations using CFs rather than profits:
- CF are objective (not impacted by different accounting policies)
- CF reflect actual timing impact (accounting smooths out fluctuations over time
- CFs measure what is avail for distribution to shareholders and other financing
- Models based on CFs are most consistent with concept of shareholder value
Operating Free Cashflow Model
OFCF model:
- uses CF generated by operations area of company, less operational reinvestment requirements
- OFCF = CFO - Investing CFs
- should always be calculated on an ungeared basis (ie add back after tax expense)
- can avoid interest calc by starting with EBITDA or EBIT
- To value an asset using OFCF; discount OFCF by the WACC. The PV then measures the value of the project
- PV of CFs = sum of OFCF(t) / ((1+k(t)) ^ t)
(where k= WACC)
- can simplify forecasts by assuming a terminal value.
- PV CFs = sum of OFCF(t) / ((1+k(t)) ^ t) + Terminal Value / ((1+k(F)) ^ F)
Equity Free Cash Flow Model
Equity Free Cash Flow
- OFCF minus debt related CF = cashflows available for shareholders
Valuations:
Value of assets =
Equity =
Value of assets = Equity + interest bearing debt
Equity = Value of Assets - Interest Bearing Debt
Enterprise Value
Enterprise value = MV of company’s operations
= Operating Assets less Operating Liabilities
Enterprise value = Net Operating Assets = equity value + interest bearing debt
after tax = ?
tax paid = ?
net tax provisions = ?
after tax = ungeared tax paid
tax paid = tax expense - (net tax provisions(t) - net tax provisions (t-1))
net tax provisions = provision for income tax + provision for deferred income taxes - provision for future tax benefits
Expected cashflows -
- why
- how
- purpose
Expected cashflows -
- why: incorporate project specific risk (CAPM prices systematic risk to required return, but does not account for project specific risk)
- how: estimate, rather than formal calculation. SUpplement with sensitivity and scenario analysis
- purpose: incorporate potential outcomes into single measure; if prob distn of cfs is asymmetric, can properly weight; assessment of possible risk outcomes, reduces chance of unrealistic base case
Terminal Value
- terminal value estimates value on last day of forecast period and needs to be discounted back to T=0
- alternatives = ?
Terminal value: Alternatives: 1. liquidate business (salvage value) 2. assumed sale of business at end (estimated sale price) 3. going concern (use continuing value)
Estimated sales price
- eg Enterprise value /EBITDA or
Enterprise Value / EBIT - Note: MUST use multiple value which is consistent with the stage of growth for the business being sold AT THE TERMINAL VALUE DATE
Continuing value:
- use continuing value when individual year forecasts have settled to a steady state
- use growing perpetuity formula (CF(F+1) / (k-g) = Terminal Value(F)
k = required return; g = perpetual growth rate - because business is continuing, there is no recovery of working capital
Relative Valuation: Multiples
- why
- sources
- Assumptions of PE ratio
Relative Valuation: Multiples
- why: PV depends on projections, which could be unrealistic
- source: trading multiples; acquisition multiples (prices paid to acquire listed companies)
- Assumptions of PE ratio:
- comparable tax rates & shareholders
- similar D/E ratios
- similar stage of capital investment
- similar working capital & funding policies
Making valuation multiples more meaningful:
Making valuation multiples more meaningful:
- sustainable earnings concept (remove abnormal effects on profit)
- use EBIT and EBITDA (removes effect of taxation and capital structure)
- use total value of debt plus equity (V = D+E) (ie enterprise value)
- make adjustments - eg tax losses / shleter; heavy capex or deprec; specific liabilities (eg legal exposure)
Activity ratios : Key activity ratios: Asset Turnover = Invested Capital Turnover = Receivables Turnover = Inventory Turnover = express in terms of days f sales; eg Receivable days of sales =
Asset Turnover = revenue / total assets
Invested Capital Turnover = revenue / invested capital
Receivables Turnover = revenue / receivables
Inventory Turnover = COGS / inventory
express in terms of days f sales; eg Receivable days of sales = (Receivables x 365) / revenue
Profitability ratios - key ratios ROE = Operating Profit Margin = Profit Margin = Return on Invested Capital =
ROE = net income / equity
Operating Profit Margin = EBIT / Revenue
Profit Margin = NOPAT / Revenue
Return on Invested Capital = NOPAT / Invested Capital
Return on Invested Capital:
- important because:
- ROE using ROIC:
- important because: shows performance on ungeared but after tax basis
- ROE using ROIC:
ROE = [ROIC pre tax + (D/E x (ROIC pre tax - Rd)] x (1-T)
ROIC pre tax = EBIT / Invested Capital
Rd = Interest rate on debt
Inputs to ROIC calculation
- Invested Capital
- Book value of net operating assets =
- Book value of net operating assets = equity attributable to shareholders in parent + interest bearing debt
Invested Capital vs Enterprise Value
- Invested Capital is the book value equivalent of enterprise value
- BV of net operating assets = eq attrib to shareholders in parent + interest bearing debt
- BV shows how much has been raised and how it has been spent.
- To calc BV equiv of Enterprise Value need to distingiosh between interest bearing debt & non interest bearing liabilities.
- Deduct non interest bearing liabilities from total assets to get either:
1. Invested Capital, Capital EMployed or Funds Employed
2. Net Operating Assets
Both measures give same result, one from financing and one from operating perspective.
Market Value Added =
Equity Market Value Added =
Market Value Added = Enterprise Value - Invested Capital
Equity Market Value Added = Equity Market capitalisation - BV of ordinary equity
NOPAT =
NOPAT = EBIT x (1-T)
= EBIT - Ungeared tax expense
Also:
NOPAT = Net Profit + Net Interest x (1-T) - Income from Non Operating Assets
NOPAT vs NOPLAT
- NOPLAT = Net Op Profit Less Adjusted Taxes.
- Same as NOPAT, but it DEDUCTS Ungeared Tax Paid instead of Ungeared Tax Expense
- If using NOPLAT, must adjust definition of Invested Capital. Net Tax provisions would not be deducted from Total Assets.
Residual Income (Economic Profit)
- what is it?
- methodology to measure
- general definition
- period of measurement
- what is it - measure whether business unit is earning adequate return on capital
- methodology to measure: eg EVA (economic value added)
- general definition:
RI(t) = NOPAT(t) - Invested Capital (t-1) x WACC(t)
[NOPAT(t): tax is based on EBIT; Invested Capital is net BV of assets at start of period] - ALso: RI(t) = (ROIC(t) - WACC(t)) x Capital Invested (t-1)
- period of measurement: each year of project’s life ie suprplus value added in that year
Advantages of using Residual Income as a performance measure (3)
- Directly incorporated cost of capital into calculation (compare with ROIC which still required comparison to WACC)
- RI incorporates ROIC, therefore can use DuPont style analysis
- RI links measures of financial performance and DCF values. Connected in 2 ways:
a) Enterprise Value = Invested Capital (at val date) + PV of all forecast RI
b) NPV = PV of all forecast RI from project - When used as valuation context, ties numbers back to accounting metrics.
- Decisions which maximise PV of RI (ie MVA) are consistent with shareholder value maximisation.
R(d) =
K (d) =
R(e) =
K (e) =
Return vs Cost:
R(d) = Return on debt
K (d) = Cost of Debt
R(e) = Return on equity
K (e) = COst of equity
Return and COst are the SAME THING. Just opposite sides of the equation. Pice paid = investment made
Price vs Value
Price is objective, value is subjective
Goal of company is to create value for shareholder
Difference is P/L
Value: analyse earnings; DCF; Multiple (eg P/E, xx times..)
Want: R > K (return > Cost)
and Value > Price (V>P
Statement of Cashflows
- steps to analyse
- Determine CFs from operating activities (ie normal activities of producing & selling G&S)
- Make adjustments to CF for investing activities (changes to capital assets - acquisitions / sales)
- Adjust for CFs from financing activities (net payments to creditors and owners (ex interest expense). ie, changes in debt & equity
Current Assets and liabilities
CA: Cash and other assets expected to convert to cash within one year. Cash &cash equiv, marketable securities, accounts receivable, inventories
CL: payments expected within one year. Acc payable, expenses payable (Inc. accrued wages & taxes), and notes payable.
Basic Balance Sheet =
Cash = (rearrange B/S equation)
Balance Sheet:
Net working capital + fixed assets = LT debt + Equity
Where Net Working Cap = (cash + other current assets) - Current liabilities
Therefore:
Cash = LT Debt + Eq + Current Liabilities - Current Assets other than cash - fixed assets
Operating Cycle vs Cash Cycle
Operating Cycle: time taken from acquisition of inventory to receiving cash
Comprised of:
1. Inventory Period (time to acquire & then sell inventory)
2. Accounts receivable period: Time taken to collect $$
(in days)
Cash Cycle: Time between paying for inventory and receiving cash payment. Comprised of:
1. Acc Payable Period (period between acquisition & pmt)
2. Cash cycle = Operating Cycle - Accounts payable period
(in days)
3 methods to calculate NOPAT
- Use EBITDA
- Use EBIT
- Use NPAT
NOPAT: 1. Use EBITDA EBITDA - D&A = EBIT EBIT - Tax paid on EBITDA = NOPAT 2. Use EBIT EBIT x (1-Tc) = NOPAT 3. Use NPAT NPAT + Interest Expense - Tax on interest = NPAT
How to check tax rate
If given Profit Before Tax and the Income Tax Expense;
ITE / Profit = tax rate (%)
Create Corporate Finance Balance Sheet
+ Operating Revenue
- Operating Expense (COGS, Selling General & Administrative)
= EBITDA
- Deprec & Amort
= EBIT - Tax (ie need ungeared)
- Net Interest Expense
- Other Non Operating
= Profit Before Tax
PE ratios when comparing similar companies may differ. Why.
- Company may be over or undervalued
- Both Div Discount Model and NPVGO model imply that the PE ratio is related to growth opportunities. A Co with higher PE ratio may have greater growth opps.
- Discount Rate - this is negatively correlated to the firm’s discount rate as it appears in the denominator. R appears in denominator of DDM and NPVGO model.
- Accounting differences can result in higher perceived EPS.
Enterprise Value to EBITDA ratio
- Enterprise value = ?
- Why remove cash?
- advantage vs PE ratio
- Why use EBITDA in denominator
- Why remove D & A?
- Enterprise value = Equity + Debt - Cash
- Why remove cash? = capture productive assets rather than include excess cash (which is non productive)
- advantage vs PE ratio: companies in same industry may use different leverage. EV includes debt and equity therefore impact of leverage on EV / EBITDA ratio is less
- Why use EBITDA in denominator: numerator and denominator must be consistent. P (per share) / E (per share) is consistent (ie PER SHARE). EV (incl D+E) therefore is divided by EBITDA
- Why remove D & A? These are not cashflows, they are sunk costs.
PE difficulties:
PE assumes: (4)
PE assumes that companies
- have similar debt/equity ratios
- have comparable tax rates and shareholders
- are at a similar stage of capital investment
- follow similar working capital and funding policies
Standardizing Statements
- why
- how
Standardize statements
- Why: need Common Size balance sheets to compare
- Also, useful to compare with competitors (eg compare cost control)
- How: Express each item as a % of total assets
Measures of Income
- Net Income
- EPS
- EBIT
- EBITDA
- Net Income
- Total Revenue - Total Expenses.
- differences in cap structure & tax. Subtract Int Exp and taxes from Op Inc
- Div payout & retained earnings closely linked to NI - EPS
- Net Inc / # shares - EBIT
- Income before unusual items.
- Op exp are subtracted from Total Ops Revenue
- Abstracts from differences in firm’s cap structure (int) & taxes - EBITDA
- EBITDA adds back 2 non cash items (D&A) and is a better view of before tax operating CF
Issues with Financial Statement Analysis
- Conglomerates (firms own diff businesses which may be unrelated)
- Globalisation (accounting standards may not be the same)
- Seasonality
- One-offs
