cash flow and cost of capital pdf

Cash Flow and Cost of Capital

Learning Objec-ves

¨  Cash flow to invested capital ¤  Free cash flow

¨  Rate cost of capital ¤  Weighted average cost of capital

¨  Economic profit ¤  Includes all costs of capital

¨  Value of the firm ¤  Fair value of invested capital

¨  Financial decision criterion over mul-ple periods

2

∑ +=

>

N

ii

i

k)(1FCFV

k roic

$-‐

$500.00

$1,000.00

$1,500.00

$2,000.00

$2,500.00

$3,000.00

$3,500.00

$4,000.00

ICIC

NIBCL

NIBCLNOA

NOA

OA

C

State-‐ment of Cash Flows

3

Statement of Cash Flows

¨  This financial statement details the change in the balance sheet cash and equivalents accounts, CE, during an accoun-ng period.

¨  CEi = CEi-‐1 + CFOi + CFIi + CFFi = CEi-‐1 + ∆CE

¨  ∆CE = CFO + CFI + CFF

¤  CFO is the cash flow from opera-ng ac-vi-es ¤  CFI is the cash flow from inves-ng ac-vi-es ¤  CFF is cash flow from financing ac-vi-es

4

Statement of Cash Flows 5

Statement of Cash Flows Net cash from opera-ng ac-vi-es From OA From NOA Net cash used by inves-ng ac-vi-es For OA For NOA Net cash from financing ac-vi-es

Balance Sheet Assets Liability & Equity CE Opera-ng

Current Liabili-es

‘Non-‐opera-ng Capital’

Invested Capital

ΔCE

CFO

Investors ∆CE = CFO + CFI + CFF

Cash Flow from Opera-ng Ac-vi-es

¨  CFO = NP + DX + ∆T – ∆NWC -‐ DG = $200 + $120 + $5 -‐ $77 -‐ $20 = $228.00

6

Net cash flow from operating activites NP 200$ DX 120$ ΔT 5$ (ΔNWC) (77)$

Δ AR (87)$ Δ INV (47)$ Δ AP 56$ Δ ITP 1$

(DG) (20)$ CFO 228$

Working Capital: Reference 7

$0

$500

$1,000

$1,500

$2,000

CE

AR

INV

APITP

WC

STD

$0

$250

$500

$750

$1,000

$1,250

$1,500OCE

AR

INV

APITP

OWC

$0

$250

$500

$750

$1,000

$1,250

$1,500

AR

INV

APITP

NWC

WC ≡ CA – CL ≡ AR + INV + CE – AP – ITP – SD OWC ≡ OCA – OCL ≡ AR + INV + OCE – AP – ITP NWC ≡ AR + INV – AP – ITP OWC = NWC + OCE

Cash Flow from Inves-ng and Financing Ac-vi-es

¨  CFI = -‐CX + ΔIS + CS = -‐$500 + $50 + $20 = -‐$430.00

¨  CFF = ΔSD + ΔLD + ΔPAR + ΔAPC – DIV = -‐$21 + $335 + $10 + $34 -‐$60 = $298.00

8

Cash flows from financing activities ΔSD (21)$ ΔLD 335$ ΔAPC 34$ ΔPAR 10$ DIV (60)$ CFF 298$

Cash flows from investing activititesCX (500)$ CS 20$ ΔIS 50$ CFI (430)$

Free Cash Flow

¨  FCF ¤  Cash flow from opera-ng ac-vi-es and opera-ng assets, CFO*, plus ¤  the cash flow from investments in opera-ng assets, CFI* ¤  FCF = CFO* + CFI*

¨  FCF is the cash flow available (accrued or paid out) to the capital providers ( investors )

¨  Also referred to as ¤  free cash flow to the firm or ¤  un-‐leveraged free cash flow

9

Balance Sheet Assets Liability & Equity CE Opera-ng

Current Liabili-es

‘Non-‐opera-ng Capital’

Invested Capital

Free Cash Flow 10

Statement of Cash Flows Net cash from opera-ng ac-vi-es From OA From NOA Net cash used by inves-ng ac-vi-es For OA For NOA Net cash from financing ac-vi-es

ΔCE

CFO

FCF CFI*

Investors ∆CE = CFO + CFI + CFF FCF = CFO* + CFI*

Free Cash Flow

¨  FCF used for ¤  Interest and coupon payments ¤  Return of short and long term debt principal

n  Return of debt capital

¤ Dividends to equity holders ¤  Buy back of equity shares

n  Return of equity capital

11

Free Cash Flow

FCF = CFO* + CFI*

CFO* = CFO -‐ IDI·∙(1-‐τ) + IX·∙(1-‐τ) = NP + DX + ∆T –ΔNWC -‐ DG -‐ IDI·∙(1-‐τ) + IX·∙(1-‐τ)

= (EBIT – IX)·∙(1 – τ) + DX + ∆T-‐ (∆OWC -‐ ΔOCE) -‐ CS + CC -‐ IDI·∙(1-‐τ) + IX·∙(1-‐τ)

= (EBIT – IDI)·∙(1 – τ) + ∆T + DX -‐ (CS – CC) -‐ (∆OWC -‐ ΔOCE) = NOPAT + DX -‐ CS + CC -‐ ∆OWC + ΔOCE

CFI* = CFI -‐ ΔIS + ΔOCE = -‐CX + ΔIS + CS -‐ ΔIS -‐ ΔOCE = -‐ CX + CS -‐ ΔOCE

12

From CFO: Remove effec-ve non-‐opera-ng cash flow and add back effec-ve cash flow to debt providers.

From CFI: Remove non-‐opera-ng cash flow, ΔIS, and add cash needed for business opera-ons, ΔOCE

At Fairway at IDI and IX transac-ons are cash

Free Cash Flow 13

FCF = CFO* + CFI* = NOPAT + DX -‐ CS + CC -‐ ∆OWC + ΔOCE -‐ CX + CS -‐ ΔOCE = NOPAT – (CX -‐ DX – CC) -‐ ∆OWC = NOPAT – ΔNC – ΔOWC = 236.68 -‐ 380.00 -‐ 117.32 = -‐$260.64 = NOPAT – ΔIC

Free Cash Flow: Summary 14

FCF = NOPAT – ΔNC – ΔOWC

NOPAT = EBIT·∙(1 – τ) +ΔT ΔNC = CX – DX -‐ CC ΔOWC = ΔAR + ΔINV + ΔOCE – ΔAP – ΔITP

If ΔT =0 and CC = 0 FCF = EBIT·∙(1 – τ) + DX – CX – ΔAR – ΔINV – ΔOCE +

ΔAP + ΔITP = EBIT·∙(1 – τ) + DX – CX – ΔOWC

•  This formula is for a firm with the same accounts as Fairway Corp •  It is not a complete general formula (nearly impossible) •  Note the symbol descrip-ons on the following slide

Free Cash Flow: Summary 15

Symbol Description

FCF Free cash flow

NOPAT Net operating profit after fax

OWC Operating working capital

NC Net capital assets (~PPE)

DX Depreciation expense

CX Capital expense (capex)

CC Cash received for capital assets sold off

AR Accounts receivable

INV Inventory

AP Accounts payable

OCE Operating cash and equivalents

EBIT Earnings before interest and tax expenses

t Average income tax rate

T Deferred tax

ITP Income tax payable

Free Cash Flow: Note 16

Damodaran defines (p. 79) Free cash flow to firm = Operating income(1-Tax rate) - (Capital expenditures – Depreciation) - Change in non-cash working capital In our notation we write FCF = EBIT·∙(1 – τ) – CX + DX – ΔOWC But is non-‐cash working capital equal to ΔOWC ? Remember working capital, WC = OCE+NOCE+AR+INV-‐ITP-‐AP-‐SD We understand that cash for opera-ons (OCE) is not available to capital providers – same for accounts receivable (AR) and inventory (INV), but ‘excess cash’ or ‘non-‐opera-ng cash’ (NOCE) is available to capital providers. Damodaran explains short term debt (SD) must be “backed out … from current liabili-es… This debt will be considered when compu-ng cost of capital and it would be inappropriate to count it twice.” p. 107 OWC=OCE+AR+INV-‐ITP-‐AP So, the answer is YES!

Free Cash Flow: Check 17

ΔCE = CFO + CFI + CFF = (CFO-‐CFO*) + (CFI-‐CFI*) + CFF + CFO* + CFI* = (CFO-‐CFO*) + (CFI-‐CFI*) + CFF + FCF

FCF = (CFO*-‐ CFO) + (CFI*-‐ CFI) – CFF + ΔCE

Cash flow from opera<ng ac-vi-es associated with non-‐opera<ng assets

Cash flow from inves<ng ac-vi-es associated with non-‐opera<ng assets

FCF = (CFO*-‐ CFO) + (CFI*-‐ CFI) – CFF + ΔCE = (259.68 -‐ 228.00) + (-‐520.32 +430.00) – 298.00 + 96.00 = 31.68 – 90.32 – 298.00 + 96.00 = -‐$260.64

Reconcile ΔCE and FCF

If no non-‐opera-ng assets, NOA=0, then ΔCE = FCF + CFF

Fairway Corp

¨  Does Fairway Corp have a problem? ¤  Nega-ve free cash flow, FCF = -‐$260.64 ¤  Posi-ve net profit, NP = $200.00 ¤  Posi-ve opera-ng cash flow, CFO = $228.00

¨  Yes, at least in the short term ¤  Rela-vely high inves-ng cash ourlow: CFI=-‐$430.00 ¤  Requiring a rela-vely high financing cash inflow: CFF=$298.00

18

Free Cash Flow To Equity

¨  Free cash flow, FCF, is the cash flow to invested capital ¤  Accrued and cash paid out

¨  The levered free cash flow or free cash flow to equity, FCFE, is the free cash flow to equity ¤  FCFE = FCF -‐ IX(1-‐ τ) + ∆DB

n  The effec-ve interest paid to debt providers is deducted n  The increase in debt is added since its available to equity providers

19

Rate Cost of Capital

¨  The cost of capital to the firm is the capital provider’s expected return on the capital

¨  Its useful to work with rate costs of capital and rates of return

¨  The rates are forward looking and based on expected market condi-ons

¨  The rate of return is rela-ve to the market value of the firm’s capital

¨  The rate cost of capital is a weighted average of the rate costs for debt and equity capital, kD and kE ¤  kD weighted average cost of debt ¤  kE weighted average cost of equity ¤  k weighted average cost of capital

n  Osen denoted WACC ‘weighted average cost of capital’

20

Rate Cost of Capital 21

Rate Cost of Capital

¨  Cost of debt, kD ¤  Interest to banks and note holders ¤  Coupons to bondholders

¨  Cost of equity, kE ¤  Dividends to shareholders ¤  Share price apprecia-on

n  Increased earnings n  Increased u-lity of earnings to equity providers

n  Increased share price to earning ra-o

n  Share buyback n  Shares become treasury stock n  Increased earnings per share for remaining shareholders

22

Cost of Equity

¨  Applies to all common equity accounts, EB ¤  RE, APC, and PAR

¨  Applies to deferred taxes, T ¨  Share price apprecia-on is obviously a return to

shareholders, but how is it a cost to the firm? ¤  The firm’s cost of equity was an ‘opportunity’ cost ¤  Think of the founder’s posi-on in the VC example ¤  The cost of equity to the founders was the VC’s expected return

on equity ¤  The equity apprecia-on would have otherwise accrued to the

founders

23

Value of the Firm

¨  Free cash flow, FCF, discounted at the rate cost of capital, k

¨  V is the fair value of the invested capital, IC ¨  The fair value of the debt capital is denoted D ¨  The fair value of the equity capital is denoted E ¨  Assume no non-‐opera-ng assets, NOA=0 ¨  V = D + E ¨  Values V, D, and E will also be used for market value

¤  The issue of fair and market value will be addressed later

24

∑ +=

N

ii

i

k)(1FCFV

Rate Cost of Capital 25

$-‐

$5

$10

$15

$20

$25

Cost of C

apita

l [$M

]

k·∙VkE·∙E

kD·∙D·∙(1-‐τ)

VEk

VD)1(k k

EkD)1(kkV

ED V

ED

ED

⋅+⋅τ−⋅=

⋅+⋅τ−⋅=⋅

+=

Note kD·∙D ~ IX

D : market value of debt E : market value of equity V : market value of capital

Economic Profit

¨  The difference between the return to invested capital and the cost of invested capital

¨  EP = IC·∙ (roic – k) ¨  EP = NOPAT – IC ·∙ k ¨  A posi-ve net (accoun-ng) profit, NP, does not ensure an

economically viable firm whereas a posi-ve economic profit does

¨  Fairway Corp ¤  Posi-ve NP and CFO ¤  Nega-ve FCF ¤  Posi-ve EP requires roic > k

26

Investment Decisions

¨  A firm’s capital investments could have the following results: ¤  roic > k: The firm’s investments increase the value of the firm ¤  roic = k: The firm’s investments sustain the value of the firm ¤  roic < k: The firm’s investments diminish the value of the firm

¨  A firm’s management is expected to increase the value of the firm ¤  Make roic > k investments

¤  Increase

n  Increase FCF, move FCF forward, decrease k (decrease risk)

∑ +=

N

ii

i

k)(1FCFV

27


¨  Each of the firm’s investments may have different risk, thus a different required roic

¨  The aggregate roic must be greater than k ¨  Each investment with roic > k should be made even if they

require the raising of addi-onal capital

28

∑ +=

N

ii

i

k)(1FCFV


Free cash flow is cash flow in excess of that required to fund all projects that have posi-ve net present values when discounted at the relevant cost of capital. Conflicts of interest between shareholders and managers over payout policies are especially severe when the organiza-on generates substan-al free cash flow. The problem is how to mo-vate managers to disgorge the cash rather than inves-ng it at below the cost of capital or was-ng it on organiza-onal inefficiencies.

Jensen, Michael C., "Agency Cost Of Free Cash Flow, Corporate Finance,

and Takeovers" . American Economic Review, Vol. 76, No. 2, May 1986.

29

Financial Decision Making

Invested Capital

NOPAT

Opera-ng Assets

Inves-ng Business ΔN, ΔOWC Strategy

Opera-ons

ΔIC true

New Capital

roic > k FCF

NOPAT = EBIT(1-‐τ) + ΔT roic = NOPAT / IC NOPAT = FCF + ΔIC ΔIC = ΔNC + ΔOWC

30

∑ +=

N

ii

i

k)(1FCFV

Further Assump-ons

¨  In subsequent topics two simplifying addi-onal assump-ons are osen made ¤ No non-‐opera-ng assets, NOA=0 ¤  IC = C ¤ No interest and dividend income, IDI = 0 ¤ No deferred taxes, T=0, thus ¤  IC = C = EB + DB ¤  TA = LE = C + OCL ¤  roic = NP / C ¤ NOPAT = EBIT·∙(1 – τ) ¤  FCF = NOPAT – ΔC = EBIT·∙(1 – τ) – ΔC

31

Essen-al Points

¨  Cash flow to invested capital, FCF ¨  Rate cost of capital, k ¨  Economic profit, EP ¨  Value of the firm, V ¨  Financial decision criterion over mul-ple periods

32

∑ +=

>

N

ii

i

k)(1FCFV

k roic

$-‐

$500.00

$1,000.00

$1,500.00

$2,000.00

$2,500.00

$3,000.00

$3,500.00

$4,000.00

ICIC

NIBCL

NIBCLNOA

NOA

OA

C

33

Firm Valua-on

OCL

T

DBC

EB

Fair value of LE and TA

PV(FCF) Value of invested capital

OCL

NOA

Value of operating assets

NOAOCL

Value of capital

OCL

NOA

IC

OCL

Book value of LE and TA

References

¨  Accoun-ng: Texts and Cases ¤  Robert Anthony , David Hawkins , Kenneth Merchant ¤  Harvard

¨  On the General Equivalence of Company Valua<on Models ¤  Joakim Levin ¤  Stockholm School of Economics

34

Appendix: Free Cash Flow 35

CFO = NP + DX + ∆T – ∆NWC -‐ DG CFI = -‐CX + ΔIS + CS = 200 + 120 + 5 -‐ 77 – 20 = -‐500 + 50 + 20

= $228.00 = -‐$430.00

CFO* = CFO -‐ IDI·∙(1-τ) + IX·∙(1-τ) CFI* = CFI -‐ ΔIS -‐ ΔOCE = 228 – 12.54 + 44.22 = -‐430 – 50 – 40.32 = $259.68 = -‐$520.32

FCF = CFO* + CFI* = 259.68 -‐520.32 = -‐$260.64

Appendix: Cash Flow Statement – Direct 36

Cash and Accrual ExpensesEquivalent at Fairway IX OXIDI

Cash Expenses Cash Revenue COGSC RCITC

Cash flows from operating activities:Cash received from customers…………………………………………..…………………………3,103$ RC

Dividends and interest received……………………………………….………………………………………19$ IDI

Total cash from operations ………………………………………………….3,122$ RC + IDI

Cash paid to suppliers and employees ……………………………………………………………………….2,730$ COGSC + OX

Interest paid ………………………………………………………………………………………………67$ IX

Income tax paid …………………………………………………………………………………………97$ ITC

Cash disbursed for operating activities ………………………………………………2,894$ Net cash flow from operating activities …………………………………………………….228$ CFO

Cash received from customers…………………………………………..…………………………3,103$ RCCash from accounts receivable …………………………………………………………………………………………87$ ΔARRevenue from sales………………………………………………………………………………………………3,190$ RDividends and interest received……………………………………….………………………………………19$ IDITotal cash from operations…………………………………………………………………3,122$ RC + IDITotal revenue from sales, interest, and dividends………………………………………..3,209$ R + IDI

FAIRWAY CORPORATIONStatement of Cash Flows

For the Year Ending December 31, 2009(in thousands)

Appendix: Cash Flow Statement – Direct 37

Cash received from customers…………………………………………..…………………………3,103$ RCCash from accounts receivable …………………………………………………………………………………………87$ ΔARRevenue from sales………………………………………………………………………………………………3,190$ RDividends and interest received……………………………………….………………………………………19$ IDITotal cash from operations…………………………………………………………………3,122$ RC + IDITotal revenue from sales, interest, and dividends………………………………………..3,209$ R + IDI

Cost of sales………………………………………………………… 2,290$ COGSIncrease in inventory………………………………………………………………………..47$ Δ INVDecrease in accounts payable…………………………………………………………………………..(56)$ ΔAPCash cost of sales……………………………………………………………………..2,281$ COGSCOperating expenses………………………………………………………………..449$ OXTotal cash expenses……………………………………………………………………2,730$ COGSC + OX

Income tax expense…………………………………………………………………….103$ IT

Increase in deferred taxes………………………………………………………..5$ ΔTIncrease in income taxes payable……………………………………………………………………1$ Δ ITPIncome taxes paid…………………………………………………………………..97$ ITC

Cash and Accrual ExpensesEquivalent at Fairway IX OXIDI

Cash Expenses Cash Revenue COGSC RCITC

Appendix: Free Cash Flow 38

Direct CFO Method

CFO = RC + IDI – COGSC– OX – IX – ITC CFI = -‐CX + ΔIS + CS = 3,103 + 19 – 2,281 – 449 – 67 – 97 = -‐500 + 50 + 20 = 228 = -‐430

CFO* = CFO -‐ IDI·∙(1-‐τ) + IX·∙(1-‐τ) CFI* = CFI -‐ ΔIS + ΔOCE = 228 – 12.54 + 44.22 = -‐430 – 50 – 40.32 = 259.68 = -‐520.32

FCF = CFO* + CFI* = 259.68 -‐ 520.32 = -‐260.64 FCF = RC – COGSC – OX – ITC + IDI·∙τ – IX·∙τ – CX + CS – ΔOCE

= 3103 – 2730 -‐97 + 6.46 – 22.78 – 500 + 20 – 40.32 = -‐260.64

39

R3,190

$

R3,190

$

R3,190

$

ΔAR

(87)

$

IDI

19$

IDI

19$

RC3,103

$

COGS

(2,290)

$

COGS

(2,290)

$

CFI

(298.00)

$ IDI

19$

OX

(449)

$

OX

(449)

$

COGS

(2,290)

$

DG20

$

DG20

$

CFO

228.00

$

OX

(449)

$

DX(120)

$

DX(120)

$

CFO*

259.68

$

ΔINV

(47)

$

EBIT

370

$

EBIT

370.00

$

31.68

$

ΔAP

56$

IX(67)

$

IT(103)

$

COGS

C + OX

(2,730)

$

IT(103

)$

IX·∙τ

(22.

78)

$

CFI

(430.00)

$ IX

(67)

$

NP

200

$

τ ·∙EB

IT(1

25.7

8)$

CFI*

(520.32)

$ IT

(103)

$

DX12

0$

IDI

(19)

$

(90.32)

$

ΔT

5$

DG(20)

$

IDI·∙τ

6.46

$

ΔITP

1$

ΔT

5$

ΔT

5$

ΔCE

96.00

$

ITC

(97)

$

ΔAR

(87)

$

NOPA

T23

6.68

$

CFO

228

$

ΔINV

(47)

$

FCF

(260.64)

$ ΔAP

56$

ΔITP

1$

ΔNW

C(7

7)$

CFO

228

$

IDI

(19)

$

IDI

(19)

$

IDI ·∙τ

6.46

$

IDI ·∙τ

6.46

$

IDI ·∙(

1-τ )

(12.

54)

$

ID

I ·∙(1-τ )

(12.

54)

$

IX67

$

IX67

$

CX(500)

$

IX·∙τ

(22.

78)

$

IX·∙τ

(22.

78)

$

D

X12

0$

IX·∙(1

-τ)

44.2

2$

IX·∙(1

-τ)

44.2

2$

CS

20$

DG(20)

$

CFO*

259.68

$

CFO*

259.68

$

CC-‐

$

ΔAR

(87)

$

CX(500)

$

CX(500)

$

ΔINV

(47)

$

ΔIS

50$

ΔIS

50$

ΔAP

56$

CS20

$

CS20

$

ΔITP

1$

-ΔIS

(50)

$

-ΔIS

(50)

$

ΔO

CE

(40.

32)

$

Δ

OC

E(4

0.32

)$

ΔO

CE

(40.

32)

$

Δ

OW

C(1

17.3

2)$

CFI*

(520

.32)

$

CFI*

(520

.32)

$

ΔIC

(497

.32)

$

FCF

(260.64)

$ FCF

(260.64)

$ FCF

(260.64)

$

Direct Cash Flow

Indirect Cash Flow

Income Statem

ent

Cash Flow From

Fina

ncing

cash flow and cost of capital pdf

Economy & Finance