chapter 02 financial statements. 2 value = + + + fcf 1 fcf 2 fcf ∞ (1 + wacc) 1 (1 + wacc) ∞ (1...

Chapter 02Financial Statements

2

Value = + + +FCF1 FCF2 FCF∞

(1 + WACC)1 (1 + WACC)∞

(1 + WACC)2

Free cash flow(FCF)

Free cash flow(FCF)

Market interest rates

Firm’s business riskMarket risk aversion

Firm’s debt/equity mixCost of debt

Cost of equity

Weighted averagecost of capital

(WACC)

Sales revenuesSales revenues

Operating costs and taxesOperating costs and taxes

Required investments in operating capitalRequired investments in operating capital

−

−

=

Determinants of Intrinsic Value: Calculating FCF

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Financial Statements

Balance Sheet

Financial Management - Reza Masri 4

Balance Sheet


Balance Sheet

The basic principles to read Balance Sheet are: LIQUIDITY: Promptness with which assets are expected

time to be converted into cash

REPAYING PERIOD: Time within which obligations are expected to be satisfied


Balance Sheet


Balance Sheet


MicroDrive Inc. December 31 Balance Sheets(in millions of dollars)

2010 2009 2010 2009Assets Liabilities and equity

Cash and equivalents $10 $15 Accounts payable $60 $30Short-term investments $0 $65 Notes payable $110 $60Accounts receivable $375 $315 Accruals $140 $130Inventories $615 $415 Total current liabilities $310 $220Total current assets $1.000 $810 Long-term bonds $754 $580Net plant and equipment $1.000 $870 Total debt $1.064 $800

Preferred stock (400,000 shares) $40 $40Common stock (50,000,000 shares) $130 $130Retained earnings $766 $710Total common equity $896 $840

Total assets $2.000 $1.680 Total liabilities and equity $2.000 $1.680

• A snapshot of financial position on the last day of a period• Snapshot changes as position changes: B/S may look different at

different times of a period

Asset: things that company owns, listed in “liquidity” order

Liabilities & Equity: claims against company’s value, listed in the “maturity” order

Income Statement



Income Statement

A basic principle to read Income Statement:

DEDUCTING PRINCIPLE

To deduct progressively costs from revenues following the production- sales cycle

Goals: To show different margins

Income Statement


Income Statement


MicroDrive Income Statements for Years Ending December 31

(in millions of dollars)2010 2009

INCOME STATEMENTNet sales $3.000,0 $2.850,0Operating costs except depreciation $2.616,2 $2.497,0Earnings before interest, taxes, deprn, and amortization (EBITDA)* $383,8 $353,0Depreciation $100,0 $90,0Earnings before interest and taxes (EBIT) $283,8 $263,0Less interest $88,0 $60,0Earnings before taxes (EBT) $195,8 $203,0Taxes $78,3 $81,2Net Income before preferred dividends $117,5 $121,8Preferred dividends $4,0 $4,0Net Income available to common stockholders $113,5 $117,8

Common dividends $57,5 $53,0Addition to retained earnings $56,0 $64,8

*MicroDrive has no amortization charges.

• Reflects financial performance during a period

Statement of Retained Earnings


MicroDrive Statement of Retained Earnings(in millions of dollars)

Balance of Retained Earnings, Dec. 31, 2009 $710,0 Add: Net Income, 2010 $113,5

Less: Dividends to common stockholders -$57,5Balance of Retained Earnings, Dec. 31, 2010 $766,0

Statement of Cash Flows


Statement of Cash Flows


MicroDrive Statement of Cash Flows for Years Ending Dec. 31(in millions of dollars)

Operating Activities Net Income before preferred dividends $117,5Noncash adjustments Depreciation and amortization $100,0Due to changes in working capital Increase in accounts receivable ($60,0) Increase in inventories ($200,0) Increase in accounts payable $30,0 Increase in accruals $10,0Net cash provided by operating activities ($2,5)

Long-term investing activities Cash used to acquire fixed assets ($230,0)

Financing Activities Sale of short-term investments $65,0 Increase in notes payable $50,0 Increase in bonds $174,0 Payment of common and preferred dividends ($61,5)Net cash provided by financing activities $227,5

Net change in cash and equivilents ($5,0)Cash and securities at beginning of the year $15,0

Cash and securities at end of the year $10,0

Net Cash Flow= Net Income – Noncash Revenues + Noncash Charges

25

What are the five uses of FCF?

1. Pay interest on debt.

2. Pay back principal on debt.

3. Pay dividends.

4. Buy back stock.

5. Buy nonoperating assets (e.g., marketable securities, investments in other companies, etc.)


Determining Free Cash Flow (FCF)

Operating Cash Flow – Investment in Operating Capital

NOPAT (Net Operating Profit After Taxes) Amount of profit a company would generate if it had no debt and held no

financial assets Take out impacts of financing & investing decisions to have pure measure of

operating performance

NOPAT = EBIT(1-Tax Rate)


Free Cash Flows (FCF)

Cash flows can not be maintained over time unless depreciated fixed assets are replaced, so management is not completely free to use net cash flows.

Free Cash Flows is the cash flow actually available for distribution to investors after the company has made all the investments in fixed assets and working capital necessary to sustain ongoing operation

FCF = NOPAT – Net investment in operating capital

Gross Investment = Net Investment + Depreciation

FCF = (NOPAT + Depreciation) – Gross Investment in operating capital

NOPAT = EBIT(1-Tax Rate)


Operating Capital

Total net operating capital = Net operating working capital + Operating long term assets

Net operating working capital = Operating current asset – Operating current liabilities

Net operating working capital = (Cash + Accounts Receivable + Inventories)

- (Accounts Payable + Accruals)


Free Cash Flows (FCF)- MicroDrive Illustration

EBIT 283,8(1-Tax Rate) 0,6NOPAT 170,28

2010 2009Cash 10 15 Accounts Receivable 375 315 Investories 615 415 Operating Current Assets 1.000 745 minusAccounts Payable 60 30 Accruals 140 130 Operating Current Liabilities 200 160 Net Operating Working Capital 800 585 plusOperating Long Term Assets 1.000 870 Total Net Operating Capital 1.800 1.455 Net Investment in Opr Capital 345

NOPAT 170,28Net Investment 345 (-)

FCF (175)


Return on Invested Capital

Capital Operating

NOPAT = ROIC

0.0946 1,800

170.3 = ROIC

MicroDrive Illustration


Market Value Added (MVA)

MVA = Market Value of Stock – Equity capital supplied = (shares o/s)(stock price) – Total Common Equity

To incorporate stock prices in the analysis as the primary goal of management is to maximize the firm’s value, hence the outstanding shares times stock price

Measures the effects of managerial actions since the inception of the company


Economic Value Added (EVA)

EVA = (Operating capital)(ROIC – WACC)

EVA = Net Operating Profit After Taxes (NOPAT) - After-tax dollar cost of capital used to support operations = EBIT(1-Tax Rate) – (operating capital)(WACC)

Focuses on managerial effectiveness in a given year


MVA & EVA - Illustration

2010 MVA = Stock price x # of shares - Total common equity = $23,00 x 50 - $896 = $1.150 - $896

2010 MVA = $254

2009 MVA = Stock price x # of shares - Total common equity = $26,00 x 50 - $840 = $1.300 - $840

2009 MVA = $460

2010 EVA = NOPAT - Operating Capital x Weighted average cost of capital = $170,3 - $1.800 x 11% = $170,3 - $198,0

2010 EVA = -$27,7

2009 EVA = NOPAT - Operating Capital x Weighted average cost of capital = $157,8 - $1.455 x 11% = $157,8 - $157,1

2009 EVA = $0,7

chapter 02 financial statements. 2 value = + + + fcf 1 fcf 2 fcf ∞ (1 + wacc) 1 (1 + wacc) ∞ (1...

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