Financial Statements and Cash Flow Analysis for Business Value Enhancement

1. Chapter 2 Financial Statements, Cash Flow, and Taxes

2. Topics in Chapter • Income statement • Balance sheet • Statement of cash flows • Free cash flow • MVA and EVA • Corporate taxes • Personal taxes

3. How can Financial Statements be used to increase value or make $ in Business • Use to evaluate investment opportunities • 1. Internal - From within company • i.e.: investments in PPE to increase FCFs & value • 2. External: • To make informed investment decisions into specific companies

4. Determinants of Intrinsic Value: Calculating FCF Sales revenues Operating costs and taxes − Required investments in operating capital − Free cash flow (FCF) = FCF1 FCF2 FCF∞ ... Value = + + + (1 + WACC)1 (1 + WACC)2 (1 + WACC)∞ Weighted average cost of capital (WACC) Market interest rates Firm’s debt/equity mix Cost of debt Cost of equity Market risk aversion Firm’s business risk

5. Income Statement

6. Statement of Retained Earnings

7. Difference b/w Interest Expense & Revenue • Int. Exp from borrowing vs. Int. Revenue from Lending Rev -CGS -Exp =EBIT -Interest =EBT -Taxes =NI

8. Balance Sheet

9. Income Statement

10. What happened to sales and net income? • Sales increased by over $2.4 million. • Costs shot up by more than sales. • Net income was negative. • However, the firm received a tax refund since it paid taxes of more than $63,424 during the past two years.

11. Balance Sheet: Assets

12. Effect of Expansion on Assets • Net fixed assets almost tripled in size. • AR and inventory almost doubled. • Cash and short-term investments fell.

13. Balance Sheet: Liabilities & Equity

14. What effect did the expansion have on liabilities & equity? • CL increased as creditors and suppliers “financed” part of the expansion. • Long-term debt increased to help finance the expansion. • The company didn’t issue any stock. • Retained earnings fell, due to the year’s negative net income and dividend payment.

15. Stock Price and Other Data

16. I/S: Accrual vs. Cash Basis

17. OR: for 2nd case

18. Statement of Cash Flows: 2015

19. Stmt of CFs – Investing Activities

20. Stmt of CFs – Financing Activities

21. Summary of Statement of CF

22. What can you conclude from the statement of cash flows? • Net CF from operations = -$503,936, because of negative net income and increases in working capital. • The firm spent $711,950 on FA. • The firm borrowed heavily and sold some short-term investments to meet its cash requirements. • Even after borrowing, the cash account fell by $1,718.

23. What is free cash flow (FCF)? Why is it important? • FCF is the amount of cash available from operations for distribution to all investors (including stockholders and debtholders) after making the necessary investments to support operations. • A company’s value depends on the amount of FCF it can generate.

24. 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.)

25. Free cash flows (FCFs) • FCF= cash available for distribution to investors. Greater the FCF, more attractive that company is to investors. Therefore, value of the firm is primarily dependent on its expected future free cash flows!

26. One More IMPORTANT Step • Value of any business asset, financial or real depends on usable, after-tax cash flows the asset is expected to produce.

27. Calculating Free Cash Flow in 5 Easy Steps Step 1 Step 2 Earning before interest and taxes Operating current assets X (1 − Tax rate) − Operating current liabilities Net operating profit after taxes Net operating working capital Step 3 Net operating working capital + Operating long-term assets Total net operating capital Step 5 Step 4 Net operating profit after taxes Total net operating capital this year − Net investment in operating capital − Total net operating capital last year Net investment in operating capital Free cash flow

28. FREE CASH FLOWS (FCF) FCF = Net Operating Profit A/Tax – Change in Outlay for Operating Capital from prior year to current year. OR: FCF = NOPAT – Net Investment in Op. Capital

29. Net Operating Profit After Taxes (NOPAT)

30. Net Operating Working Capital (NOWC) Difference in C/A & C/L used to operate business. NOWC = CA - CL NOWC= (cash+A/R+Inv) - (A/P + Accruals) All non-interest bearing CA & CL

31. Total Operating Capital = = NOWC + Net Plant & Equip. = S/T Op Cap + L/T Op Cap = Fixed Assets - Accum. Deprec =Net Fixed Assets

32. NOPAT = EBIT(1 - Tax rate) NOPAT15 = $17,440(1 - 0.4) = $10,464. NOPAT14 = $125,460. Net Operating Profit after Taxes (NOPAT)

33. What are operating current assets? • Operating current assets are the CA needed to support operations. • Op CA include: cash, inventory, receivables. • Op CA exclude: short-term investments, because these are not a part of operations.

34. What are operating current liabilities? • Operating current liabilities are the CL resulting as a normal part of operations. • Op CL include: accounts payable and accruals. • Op CL exclude: notes payable, because this is a source of financing, not a part of operations.

35. NOWC15 = ($7,282 + $632,160 + $1,287,360) - ($324,000 + $284,960) = $1,317,842. NOWC14 = $793,800. Operating CA Operating CL NOWC = - Net Operating Working Capital (NOWC)

36. Total net operating capital (also called operating capital) • Operating Capital= NOWC + Net fixed assets. • Operating Capital 2015 = $1,317,842 + $939,790 = $2,257,632. • Operating Capital 2014 = $1,138,600.

37. FCF = NOPAT - Net investment in operating capital = $10,464 - ($2,257,632 - $1,138,600) = $10,464 - $1,119,032 = -$1,108,568. How do you suppose investors reacted? Free Cash Flow (FCF) for 2015

38. Uses of FCF

39. ROIC = NOPAT / operating capital ROIC15 = $10,464 / $2,257,632 = 0.5%. ROIC14 = $125,460 / $1,138,600 =11.0%. Return on Invested Capital (ROIC)

40. The firm’s cost of capital is 10%. Did the growth add value? • No. The ROIC of 0.5% is less than the WACC of 10%. Investors did not get the return they require. • Note: High growth usually causes negative FCF (due to investment in capital), but that’s ok if ROIC > WACC. For example, in 2008 Qualcomm had high growth, negative FCF, but a high ROIC.

41. Economic Value Added (EVA) = Estimate of business’s true economic profit for yr., which differs from acctg income. EVA = residual income that remains after cost of all capital (incl. equity capital) has been deducted from Net Operating Profit After-Tax (NOPAT), whereas, Acctg Income does not consider cost of equity capital, only debt.

42. Economic Value Added (EVA) = = NOPAT- (After-tax Cost of Capital) = NOPAT- ($ Total Op. Cap)(% Cost of Captl) = NOPAT – ($ Op. Cap)(WACC) • Where WACC is wtd. ave. cost of capital

43. Economic Value Added (EVA) • EVA = NOPAT- (After-tax Cost of Capital) • EVA = NOPAT- (Total Capital)(WACC) • Where WACC is wtd. ave. cost of capital

44. EVA = NOPAT- (WACC)($ Op.Capital) EVA15 = $10,464 - (0.1)($2,257,632) = $10,464 - $225,763 = -$215,299. EVA14 = $125,460 - (0.10)($1,138,600) = $125,460 - $113,860 = $11,600. Economic Value Added(WACC = 10% for both years)

45. Stock Price and Other Data

46. Market Value Added (MVA) • MVA = Market Value of the Firm - Book Value of the Firm • Market Value = (# shares of stock)(price per share) + Value of debt • Book Value = Total common equity + Value of debt (More…)

47. Market Value Added (MVA) • MVA =Difference between market value of a firm’s stock and the amount of Equity capital supplied by Shareholders. • Greater the MVA, greater the value generated for stockholders. • MVA=Market Value of Equity - Book Value of Equity • MV reflects future profitability, while BV represents historical cost

48. MVA (Continued) • If the market value of debt is close to the book value of debt, then MVA is: • MVA = Market value of equity – book value of equity

49. 2015 MVA (Assume market value of debt = book value of debt.) • Market Value of Equity 2015: • (100,000)($6.00) = $600,000. • Book Value of Equity 2015: • $557,632. • MVA15 = $600,000 - $557,632 = $42,368. • MVA14 = $850,000 - $663,768 = $186,232.

50. Key Features of the Tax Code • Corporate Taxes • Individual Taxes