Neil G. Cohen, DBA, CFA School of Business The George Washington University Washington, DC USA
ngcohen@gwu.edu
! 2013 Neil G. Cohen. All rights reserved. 2 July 2013
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TABLE OF CONTENTS CHAPTER 1 - USING FINANCIAL STATEMENTS INTELLIGENTLY The Close Relationship between Finance and Accounting: The IS/BS Model " Structure and Terminology Issues #$ Reliability of Financial Statements Bogus or Accurate? #% CHAPTER 2 - FINANCIAL STATEMENT ANALYSIS WITH RATIOS Purpose of Financial Ratios ! Diagnostic Metrics &# Taxonomy of Financial Ratios &# The DuPont Formula &' Ratio Interpretation Template &( Operating Leverage and Breakeven Levels &% CHAPTER 3 - FORECASTING FINANCIAL STATEMENTS & DETERMINING EXTERNAL FINANCING NEEDED Percentage-of-Sales Forecasting of Financial Statements & Determining External Financing Needed )) The Short-Form Forecasting Model )) Interpreting External Financing Needed '' CHAPTER 4 - FINANCIAL ARITHMETIC THE TIME VALUE OF MONEY Basics of Time Value of Money '% Tables for Compounding & Discounting ") Automating the Calculations Using HandyCalc "* CHAPTER 5 - CAPITAL BUDGETING & COST OF CAPITAL Overview of Capital Budgeting $# Calculate the Discount Rate Weighted Average Cost of Capital (k wacc ) (+ Calculate Decision Criteria: Net Present Value, Profitability Index, Internal Rate of Return, Payback Period (% CHAPTER 6 - EQUITY VALUATION The Basics *( Dividend Discount Model (DDM) %* Free Cash Flow Equity Valuation (FCF) Model %% Market Multiples Equity Valuation Model #+& Nine Elements in the Equity Valuation Process A Summary #+$ CHAPTER 7 - DEBT VS. EQUITY FINANCING & LEASE VS. BORROW-TO-BUY ANALYSIS The Debt vs. Equity Decision #+( The Lease vs. Borrow-to-Buy Decision #&#
4 The image on the book cover depicts five key concepts in financial decision-making:
Return and Risk, always considered together, refer to the duality at the root of finance theory, where return is a rate of return on investment and risk is the variability over time in that rate of return. Growth is the objective of (most) businesses, to grow revenues, profits, and the value of the business. Sustainability refers to the hope that growth in revenues, profits, and stock price will continue into the future. Cash Is King! (the kings crown) refers to the maxim that if its not cash money (the stack of money), its not real. The accountants measurement of net income and retained earnings do not represent money that can be spent (the cigar box, where the money is kept in a small business); only cash can be spent.
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CHAPTER 1 USING FINANCIAL STATEMENTS INTELLIGENTLY
The Close Relationship between Finance and Accounting: The IS/BS Model
Introduction
Learning Objectives 1. Understand the layout and terminology of an income statement 2. Understand the layout and terminology of a balance sheet 3. Understand the layout and terminology of a cash flow statement 4. Understand the link between the income statement and balance sheet 5. Understand why Cash is King!
Accounting is a Foreign Language
This is a discussion about linguistics you are learning a foreign language with all the challenges that involves: irregularities, too many synonyms and code switching, which to a linguist, is changing from one language to another in the same sentence or paragraph. Accountants and financial analysts dont make it easy for users of financial statements, with so many different terms and formats for presenting financial statements. This makes it frustrating for learners. Relax about it; as in language learning, practice and repetition is the key. You will get better at it as you go along. Its a skill, and building a skill takes time.
Cash Basis versus Accrual Accounting
Accrual accounting records all transactions, whether or not cash has changed hands. For example, if you pay employees every two weeks, the salary due them accrues day-by-day on your books as a current liability you owe to them. Similarly, if you obtained inventory on credit, then sell it to your own customer before you pay your supplier for it, the cost of the goods sold includes the cost of those items.
Cash basis means that transactions are recorded only when cash changes hands: merchandise is sold for cash or an employee's salary is paid in cash. This means that when merchandise is sold on credit, or when raw materials are bought from suppliers on credit, no record of the transaction goes into the company's books if the cash basis is used. Accordingly, an income statement drawn at any given time, under the cash basis, will not reflect all of the business's transactions, and may provide a misleading picture of business performance.
Under accrual accounting, such transactions must be included, as they should be, because they are costs of doing business. Under the cash basis, they would be excluded, understating the cost of doing business and overstating income tax and profit. Some businesses, especially those dealing in services rather than products and where cash is paid, can operate on the cash basis without great danger of having distorted financial statements. It is required under the accounting law, however, that most businesses use accrual accounting. This accounting method matches sales revenue against those
6 expenses incurred which generated the revenue for the accounting period, whether or not cash has changed hands.
The IS/BS Model
Financial statements describe the operations of a business - the scorecard for the business. Shown above is a summary diagram of the Income Statement/Balance Sheet accounting model of the business - organizing financial data so the performance of the business can be measured and controlled. The accounting model consists of the income statement, the balance sheet, and the cash flow statement, each of which is discussed in the material that follows. The information in financial statements is summarized with financial ratios, the subject of Chapter 2. Dont worry about that now. Gain a solid understanding of the financial statement terminology and structure first things first!
View the balance sheet as a snapshot of a business, freezing action at a moment in time. It lists the dollar amount in each asset, liability, and equity account. In contrast, view the income statement as a moving picture summarizing the flow of revenues and expenses during the period of time. Where the balance sheet is written as of an ending date (the moment in time), the income statement is written to cover a period of time (month, quarter, year). The balance sheet and the income statement are linked when the profit retained in the business, shown on the final line of the income statement, is added to the equity section of the balance sheet, increasing the owners investment in the business, or decreasing it if there is a loss.
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Balance Sheet is a SNAPSHOT of account balances FROZEN at a POINT in time
Income Statement is a MOVING PICTURE of transactions FLOWING over a PERIOD of time
ASSETS = LIABILITIES + EQUITY
COMMON EQUITY = COMMON STOCK + RETAINED EARNINGS
The universal accounting equation is shown in the box above: Assets equal liabilities plus equity. Look at the income statement/balance sheet model and relate what you see in the box, the accounting equation, to the structure of the financial statements depicted in the model. Since the last line on the income statement summarizes the results of running the business during a period of time.sales revenue minus expenses minus taxes minus dividends equals profit reinvested in the business.that profit reinvested is transferred into the equity account on the balance sheet. The balance sheet then portrays the position of the business at a moment in time at the end of the accounting period.
An accountant is obligated to prepare financial statements that truly and fairly portray the results of business operations, following accounting principals and the law. No matter what country is involved, these are the fundamental principles: the business is assumed to be a going concern completeness truth clarity of presentation consistency with prior year agreement with closing balance sheet of previous year accrual accounting with matching of revenue and expenses prudence disclosures individual valuation of assets and liabilities inter period allocation of income and expense
You will soon realize that formats and terminology for financial statements vary widely. To keep the focus clear and unambiguous, the formats used throughout this book are a
8 composite of illustrative financial statements from United States Generally Accepted Accounting Principles (USGAAP), International Accounting Standards (IAS), and International Financial Reporting Standards (IFRS) 1 . This approach minimizes confusion for those who are learning about financial statements for the first time. As your skills develop and your understanding deepens, you will be able to work with any format and terminology that comes your way, because USGAAP, IAS, and IFRS are variations on the same theme.
Layout and Terminology of the Income Statement
Revenue is also called sales, net sales, or turnover in some countries. Cost of sales, sometimes called cost of goods sold (CGS), is the cost to the business of either buying and/or producing the goods/services it sells. It includes wages, cost of operating a factory, depreciation, and other direct and indirect production costs. Cost of sales is a combination of fixed and variable costs. Sales minus cost of sales equals gross profit, also called gross margin. It represents the amount remaining to cover general overhead expenses after deducting the cost of making or buying the goods that are sold.
1 A concise, clearly written article on IFRS is Illustrative Financial Statements Presentation and Disclosure Checklist: International Financial Reporting Standard for Small and Medium-Sized Entities. Find it on this website: http://www.ifrs.org/IFRS+for+SMEs/IFRS+for+SMEs+and+related+material.htm
9 Distribution costs, sometimes called selling costs, are those connected with sales and marketing activity. Administrative costs are the general overhead of the business. Research and development expense can be included here or given a separate account title of its own. Although distinctions between fixed cost and variable cost are rarely found in published financial statements, you can think of distribution costs as more variable than administrative costs although both categories include both fixed and variable components. Depreciation and amortization expense recognizes the usage of fixed assets such as buildings (but not land, which is not depreciated), machines, and equipment. Many income statements do not show depreciation expense as a separate item. Instead, it is included as part of cost of sales, distribution costs, administrative costs, etc. Remember that depreciation is a non-cash charge. An expense such as paying salary to workers means that cash is paid out a cash charge. Depreciation is a non-cash charge because no cash is paid out. It is an expense that recognizes the use of previously purchased fixed assets. Depreciation and amortization expense is linked to the balance sheet when the annual expense is added to the account for accumulated depreciation and amortization on the balance sheet. For example, an asset is purchased for $1,000 to be depreciated over 10 years. Each year there is $100 depreciation expense on the income statement. After the first year, the fixed asset is booked at $900, the $1,000 purchase price minus $100 depreciation for the first year. After ten years, the fixed asset will be valued at $0 because $100 of depreciation for each of 10 years accumulates to $1,000. Other operating costs is a catch-all account for other items Restructuring costs will be zero unless these non-recurring costs occur. Profit from operations is gross profit less all operating expenses. This account is also called earnings before interest and taxes (EBIT). It is also called operating profit, and is sometimes it is called trading profit. Interest, financing expense is interest paid on borrowed money. Income from investments is non-operating income Disposal of operations will be zero unless these non-recurring costs occur. Profit before tax is the sum of operating profit or loss, financial profit or loss, and extraordinary items. Income tax is income tax. Profit after tax is profit before tax minus income tax. This is the so-called bottom line of an income statement, the figure showing how well the business has performed during the accounting period. Minority interest, other provides a place to enter these special categories, if relevant. Dividends means cash dividends paid to owners Other is a catch-all category Reinvested in the business also called increase in retained earnings, which is transferred to the balance sheet to show the increase (or decrease if a loss occurs) in the stockholders equity from the current periods activity.
10 Layout and Terminology of the Balance Sheet
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Assets are listed in order of liquidity (that is, the ease with which the asset can be converted into cash). Liabilities are listed according to the priority claims of creditors. Equity is the difference between assets and liabilities; it represents the book value of the owner's equity in the business. It is called book value because it is the amount on the books. It has little or nothing to do with the market value of the business, as you will see later in the course. Equity is considered a residual because it is the amount remaining after what is owed (liabilities) is subtracted from what is owned (assets).
Current assets: Cash & equivalents includes the cash in the till, cash in the bank, and highly liquid, high quality securities with short maturities Investments are liquid investments, usually securities Trade receivable, also called accounts receivable, is the total amount of money owed to your company by the customers who have purchased goods or services on credit. The credit terms may be very short, such as 15 days, or very long, up to one year. If you know from past experience that a certain percentage of these accounts, say 2%, will never be collected, the accounts receivable entry should be net of the estimate of uncollectible accounts. Deduct an estimate of bad debts to get net accounts receivable. Inventory means goods available for sale to customers, and includes all costs involved in producing or obtaining them. In manufacturing, it is divided into three categories: raw materials, work-in-progress, and finished goods. Include only goods available for sale; office supplies, spare parts for production equipment, and gasoline for delivery trucks may not be classified as inventory items. Other current assets is a catchall category.
Non-current assets, also called fixed assets: Property, plant and equipment-gross are assets with useful lives in excess of one year. Note that land is not depreciated it does not wear out or get used up. Accumulated depreciation and amortization is the aggregate, cumulative depreciation and amortization expense from all income statements, year-by-year. Property, plant, and equipment-net is property, plant and equipment less accumulated depreciation and amortization. Investment property is ambiguous and depends on the situation, likely to be an ownership interest in another business Goodwill is the excess of market value paid over book value in an acquisition. It may also include intangibles such as intellectual property or trademarks. Other is a catchall category.
Current liabilities: Trade and other payables, also called accounts payable, is the amount of money owed to suppliers for goods or services bought on credit. The credit terms can be very short, say 10 days, or up to one year, and still be considered a current liability. This account is vendor financing. Retirement benefit obligation is pension payments due to retired employees within one year. Tax liabilities, also called income tax payable or accrued taxes, is the income tax due to governments within one year. Leases due in 1 year is short-term lease payments due Loan, debt due in 1 year is the principal amount of borrowings due in one year.
12 Other is a catchall category.
Non-current liabilities, sometimes called long-term debt: Retirement benefit obligation is aggregate pension payments due to retired employees. Deferred tax liabilities are the reconciling entry between the income tax calculated on GAAP taxable income and the income tax calculated on the income tax return. An alternative definition is the difference between taxes due and taxes paid under different accounting regimes, such as accelerated depreciation used on the tax return and straight-line depreciation used on GAAP financial statements. Finance leases due after 1 year is the present value of future lease payments. Loans, debts due after 1 year is the principal amounts of borrowings. Other is a catchall category.
Shareholders equity (Net worth): Preferred stock is the par value of preferred shares outstanding. Common stock is the par value of shares issued to shareholders. Additional paid-in capital is the difference between the amount the investor paid for shares issued and the par value of the shares when the shares were issued. In modern accounting, common stock and paid-in-capital can be summed, to represent the money paid by owners when the shares were issued to them. Other is a catchall category. Retained earnings is accumulated profit (loss) since the business started. It is increased (decreased) each year when profits reinvested in the business (from the income statement) are added to the previous balance of accumulated profits on the balance sheet. (Treasury stock is a deduction for common stock repurchased by the corporation. It is a misnomer because stock repurchase reduces shares outstanding repurchased shares no longer exist after they are repurchased they are cancelled - therefore, treasury stock does not exist and does not appear as an entry on this balance sheet. Total equity (also called net worth) is the sum of preferred stock, common stock, additional paid-in-capital, other, and retained earnings Minority interest is a catchall category.
The Link between Income Statement and Balance Sheet
The above sections discussed the income statement and the balance sheet independently. From now on, the two financial statements will be discussed as a set, because one cannot be interpreted without the other. From our discussion of income statements, you should remember that the bottom line is profit after tax minus dividends: profit reinvested in the business. This is the result of the moving picture of business operations for the year (or quarter or month). How do the results of the moving picture get into the snapshot shown by the balance sheet? The answer is simple: profit (loss) reinvested in the business, shown at the bottom of the income statement, is added to the accumulated profit (loss) on the balance sheet.
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Keep in mind that : income statement reinvested profit is for only one period of time the period for that particular income statement only. reinvested profit on the balance sheet is the accumulation of all reinvested profits from all the income statements since the business began.
Similarly, keep in mind that: depreciation and amortization expense on the income statement is for that period only. accumulated depreciation and amortization on the balance sheet is the cumulative depreciation expense from all the income statements. Learn not to confuse depreciation expense (income statement) with accumulated depreciation (balance sheet). Eventually, accumulated depreciation reduces the book value of an asset to zero; signifying that is has been fully depreciated.
Profit versus Cash
Profit after tax is not the same as cash (unless cash basis accounting is used). Profit is a measurement of revenue minus expenses minus tax transactions, as defined by GAAP rules for accrual accounting, whether or not cash changes hands. As actual cash is collected, some goes to pay expenses, some goes to increase assets, some goes to pay liabilities, and some goes to pay dividends. A growing business almost always spends more cash than it receives, using external funds to close the gap. Therefore, please, never confuse cash with profit - they are not the same. A business with large and growing profit often has a cash deficit until it raises money from debt or equity financing. Material presented in subsequent weeks will emphasize why CASH IS KING. Cash is money. A firm can have positive net profit yet still go out of business because of a lack of cash .A business can invest money in working capital and fixed assets, or use the money to repay debt and give dividends to shareholders. Profit and retained earnings are creatures of accounting methods, not money. Lots of effort will be made during the weeks that follow to clarify this notion further. It is one of your key learning objectives - you cant afford to misunderstand it.
Layout and Terminology of the Cash Flow Statement
Cash flow statements are also called: Statement of sources and uses of funds Statement of sources and application of funds Statement of funds flows Statement of changes in financial position Funds statement
Although there are variations in the layouts of cash flow statements, all of them are used as a bridge between the income statement and the balance sheet, for the purpose of tracing how funds were used and where those funds came from. A cash flow statement shown on the following page is derived from the income statement and balance sheet it is not a unique statement. It rearranges the income statement and balance sheet data.
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15 Classification of Sources and Uses of Funds
The table below shows a simple summary for understanding the difference between a source and a use of funds.
The cash flow statement summarizes the where got-where gone situation sources and uses of funds. It is divided into three categories, operating activities, investing activities, and financing activities. The sum of cash inflows and outflows is the annual increase or decrease in cash. That figure, adjusted for the effect of foreign exchange rate changes and the cash balance at the beginning of the year, gives the cash balance at the end of the year.
Operating activities are income statement flows. GAAP requires interest paid to be entered in this category, even though it seems more like an investment activity. Net cash provided by operating activities is sometimes abbreviated CFFO, Cash Flow From Operations. Investing activities represent increases or decreases in balance sheet asset accounts. Financing activities are increases or decreases in balance sheet liability or equity accounts adjusted by Dividends from the income statement.
Know the three parts of the Cash Flow Statement, as it is shown above, know that it is derived from the income statement and balance sheet and is not a unique statement, and know the source/use definitions in the table above. Your primary effort should be placed on the income statement and balance sheet.
Summary
You must know, intimately, the format and terminology of income statements and balance sheets, however boring it may seem at this early point in the course. These statements are the way we portray the companies we are talking about.
Above all, you must appreciate that net income on the income statement does not represent cash. It sounds silly to say it, but, only cash (on the balance sheet) is cash. It is the only money you can spend. You cant spend profit and you cant spend retained earnings. They may be accounting accruals, creations of accounting rules, but they are not cash. Thats why we say Cash is King! There will be a lot more said about this as the course rolls on.
ASSET LIABILITY + EQUITY increases in these accounts increases in these accounts are USES of funds are SOURCES of funds decreases in these accounts decreases in these accounts are SOURCES of funds are USES of funds
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Structure and Terminology Issues
Learning Objectives 1. Realize that financial statements are presented in many variations with no standard format 2. Realize that terminology of financial statements in full of synonyms and ambiguity 3. Learn to look for the context of the financial statements and interpret the details accordingly
Be Aware of Multiple Layouts for Financial Statements
You might expect published financial statements to follow a rigid layout where all income statements and balance sheets have the same format, with the same titles presented in the same order. Although accounting standards specify a detailed order of presentation and set of account titles, considerable variations from this layout are found in practice. You should not be bothered by variations from the system of accounts presented in the accounting standard. What you need to know is the logic of how the financial statements are organized and how they fit together, and to be flexible enough to interpret the context of what is presented. Its frustrating for the learner, I know, but it will become clear once you reach a critical mass of knowledge.
Be Aware of Different Words Used to Name the Same Account Titles
Account names in financial statements can have more than one name, causing confusion when you look at statements from different companies in different countries. You must be aware of the synonyms because they occur so often. For example, profit after tax can also be called either after tax profit, net profit, earnings after tax, or net incomeall synonyms. You must be aware of the synonyms because they occur so often. For example, profit after tax can also be called either after tax profit, net profit, earnings after tax, or net incomeall synonyms. You must be aware of the synonyms because they occur so often.
We dont know if authors use terminology shifts on purpose to test your ability to be flexible, or if they are merely being careless. There is no nationwide or worldwide organization that decrees standard terminology. Normally, you can determine the meaning of an unfamiliar term from the context. Alternatively, use the list of synonyms.
Listed below are groups of synonyms for terms that are used interchangeably, categorized as: income statement balance sheet other
Capital budgeting Investment decision Cost-benefit analysis Project analysis
Summary
This discussion made you aware of the too-numerous synonyms involved in financial statement terminology. We might wish for more consistency, but know that we wont get it, and must be ready to deal with financial statements as we find them. As you gain experience as a user of financial statements, familiarity with the context will permit you to interpret them properly in spite of terminology and format shifts.
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Reliability of Financial Statements Bogus or Accurate?
Learning Objectives 1. Understand purpose of financial statements 2. Understand why many financial statements are bogus
Is the Measuring Device Rigid or Elastic?
Now that you have begun to master the terminology and structure of financial statements, do a reality check about the usefulness of this information.
First off, think about this metal ruler. One inch is always one-inch long. The aluminum does not stretch or shrink. It always stays the same. The user of the ruler relies that the measuring device is consistent.
Second off, think of the elastic band in these sweat pants. The tag inside says the size is 34, but you can stretch them to a 38 at least, or you can shrink them to maybe a 32 or 30.
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Are the accounting principles that lie behind financial statements more like the aluminum ruler or the sweat pants waistband? We might like it better if the answer was ruler but that is the wrong answer. At their best, financial statements are put together using rules with lots of flexibility. If this shocks you, give it some thought. You dont want to be an overly trusting and nave user of financial statements.
Accounting fraud is vigorously prosecuted all over the world. Huge fines are paid. Huge out-of-court settlements are paid by offending accounting firms when users financial statements successfully claim that they relied on those statements and were materially misled. Jail terms for perpetrators of accounting fraud are not unusual. Although the link below is about the law in the United States, it is included for your reference:
http://www.sarbanes-oxley-forum.com/
Summary
Published financial statements are not what they seem. Dont be reticent about taking them with a grain of salt. Even in the absence of covert fraud, there is a lot of bogus information in financial statements. Its healthy to view them as instruments used by corporations to put their best foot forward.
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CHAPTER 2 FINANCIAL STATEMENT ANALYSIS WITH RATIOS
Financial ratio analysis summarizes the data from the income statement and balance sheet so you can measure the performance of a business. Also, ratios are the basis for making forecasts of future operations.
Learning Objectives 1. Interpret a financial statement using financial ratios 2. Understand the difference between comparisons of historical trends within a company and comparisons of ratios between companies 3. Understand the power of the DuPont formula 4. Understand the limitations of financial ratio analysis 5. Perform financial ratio analysis in an Excel spreadsheet
Purpose of Financial Ratios - Diagnostic Metrics
Think of financial ratios as measures of the relative health or sickness of a business. Just as a physician takes readings of a patient's temperature, blood pressure, heart rate, and blood count, a manager takes readings of a firm's liquidity, leverage, efficiency, profitability, and growth. Where the physician compares the readings to generally accepted guidelines such as a temperature of 98.6 degrees as normal, the manager uses trends over time within the company comparisons to peer companies and industry benchmarks.
By itself, a financial ratio means little. Its meaning comes from making the proper comparisons.
As you look at the discussion below, keep track of where the input figures for the ratios come from. Some ratios are made up of income statement figures, some are made up of balance sheet figures, and others use figures from both income statement and balance sheet. The RATIO INTERPRETATION template lists each ratio by name, and also shows its numerator and denominator, a useful display to help you remember the ratios and see their sources.
In interpreting a ratio, remember that it results from many inputs. You may not be able to say that the ratio is bad, for example, solely because the numerator is too high. Instead, the problem may be that the denominator is the cause of the problem rather than the numerator. Be careful about jumping to conclusions before you examine all of the inputs making up the ratio.
Taxonomy of Financial Ratios
The ratios are listed in these categories: Liquidity Leverage Efficiency/Asset-Use
22 Profitability DuPont Formula a summary model including three of the above ratios, leverage, efficiency, and profitability (but not liquidity) multiplied together resulting in return on equity Growth rates
Liquidity Ratios
Liquidity ratios measure the ability of the company to pay its bills. A liquid asset is one that can be converted to cash quickly without suffering a loss of value. Remember that assets are listed in the balance sheet in increasing order of relative liquidity. Keep in mind that current assets are uses of funds increasing them means increased investment in the business, and vice versa. Similarly, current liabilities are sources of funds, such as supplier creditincreases provide more available funds to invest in the business. The current ratio compares current assets to current liabilities to show by how much current assets (cash plus accounts receivable plus inventories) exceeds current liabilities (bills that must be paid relatively soon). A lower current ratio means that you are in a riskier position, because fewer liquid assets will be there to cover current debts. A high ratio means greater liquidity. But a high ratio may also mean that you have too much invested in current assets. Remember, finance involves trade-offs. You may sleep better at night knowing that the current ratio is high and you are in not danger of becoming insolvent (running out of liquid assets so bills cannot be paid). The other side of the issue is that excessive investment in current assets reduces your rate of return, because more assets mean greater investment, the denominator in the rate of return calculation. The quick ratio, sometimes called the acid-test ratio, is similar to the current ratio. The difference is that inventory, the least liquid current asset, is deducted from the numerator of the fraction, because inventory can be liquidated less quickly than cash or accounts receivable. Days sales in receivables, also called collection period, measured in number of days, shows how long it takes to collect from customers who get credit. The smaller the number of days, the more efficient the collections, and the less money must be invested in offering credit to customers. If customers demand relaxed credit terms, keeping receivables too low may reduce sales. The numerator of the fraction is net receivables (after deducting uncollectible accounts). The denominator is sales divided by 365, which gives sales per day. Days cost of goods sold in inventory shows how many days of production (or purchases from vendors) is invested in inventory. The smaller the number of days, the better, because it means less money invested in inventory. The risk of stock- outs must be considered; if inventory is too low, sales might fall when orders cant be filled. Another way to measure the same thing is inventory turnover. It shows how many times inventory is sold (turns over) each year, a measure of inventory efficiency. The higher the ratio the better, because it implies a smaller inventory for the level of sales, and a smaller inventory means that less money is invested in the business, raising rate of return. A ratio that is too low might imply the risk of running out of inventory and losing sales. A ratio measured in days, like days cost of goods sold in inventory, is easy to interpret because 45 days vs. 90 days is easily interpreted. Days cost of sales in payables, also called payment period, measured in number of days, shows how long it takes to pay suppliers who offer credit. The smaller the number of days, the quicker the suppliers are getting paid. The
23 numerator of the fraction is net payables. The denominator is cost of sales divided by 365, which gives cost of sales per day.
Leverage Ratios
Leverage ratios measure the use of borrowed money. They are measures of financial risk, which means the likelihood of insolvency or bankruptcy if you are unable to pay debts such as interest payments and repayment of loan principal. High leverage ratios are not automatically considered bad but should be interpreted as indications that the manager decided to use debt aggressively. The hope is to grow faster or increase profits by putting borrowed money to work. This is a reasonable goal. Understand that such a strategy involves risk. You must consider the risk-return trade-off in deciding how much debt is acceptable. Long-term debt to total capital compares the sum of long-term liabilities in the numerator to the sum of long-term liabilities plus equity in the denominator. The higher the ratio, the greater the use of borrowing, and the greater the financial risk. IAS requires that financial leases be included in long-term liabilities. Long-term debt to equity is the ratio of permanent debt financing to the funds supplied by owners. Remember that the funds supplied by owners, equity, includes money paid for shares when it was issued combined with all accumulated profits reinvested in the business during its entire history. Times interest earned (coverage ratio) indicates how easy or how hard it is to cover fixed interest payments on borrowed money. The numerator of the fraction is the funds available to pay interest, what remains after all operating expenses are deducted from revenue, i.e., EBIT. The denominator of the fraction is interest that must be paid. Think of it as the number of times the funds available for interest payments cover the interest that must be paid. The higher the coverage ratio, the safer, the greater the cushion available if EBIT falls. Full burden coverage restates the times interest earned ratio to include lease payments. Times interest earned considers only the interest expense part of borrowing. Full burden treats leases as fixed expenses just like debt, providing a more comprehensive indicator about whether operating profit is sufficient to service both leases and debt. Efficiency/Asset-Use Ratios
The purpose of your business is to generate revenue and profits. Therefore, you invest in assets to create the business and produce the product or service you sell. So you want to measure how good you are at using assets to generate revenue, hence the efficiency ratios. Fixed asset turnover measures the efficiency of fixed assets in generating revenue. This is a turnover ratio, so a higher result is a good result. Total asset turnover measures the overall asset efficiency.
Profitability Ratios
Profitability ratios measure profit in relation to the income statement and balance sheet. Gross margin measures how much of each euro of revenue is left after cost of goods sold is deducted. It is a measure of how much is left to pay other expenses after the cost of making or buying the goods is deducted, before consideration of other operating expenses.
24 Operating profit margin measures what is left after all operating expenses are deducted from the revenue figure. Return on sales (ROS) compares profit after tax to sales. It shows how much of each euro of sales is left after all expenses, including income taxes, are paid. It does not consider repayment of debt principal, which is not an expense Return on assets (ROA) compares profit after tax to total assets. Return on equity (ROE) compares profit after tax to the funds supplied by owners, equity. This may be the most important number from the viewpoint of the owner, because it measures the rate of return on the money invested in the business. Return on invested capital (ROIC) compares EBIT after tax to the assets used to generate sales. Where ROS and ROA are dependent on and biased by the extent of debt financing used, because the numerator is profit after tax, ROIC is a performance metric independent of financing, because its numerator is after tax EBIT no interest expense is considered in the calculation as it is in ROS and ROA.
In the table below, Company A has earnings after tax (net income) of $18 with a ROE of 18%, while Company B has 4 times the earnings after tax but a ROE of 7.2%, less than one-half that of Company A. The bottom three lines of the example show three rate of return metrics. Company Bs are all the same because it has no debt (financial leverage). The ROIC measure removes the impact of the financial policy differences an important lesson.
The DuPont Formula
The DuPont formula is a powerful diagnostic tool because it decomposes Return on Equity (ROE) into three components. It is a concise and focused look at how profitability, leverage, and efficiency combine to determine the return on equity (ROE) of a business. The three terms are multiplicative, their product being ROE. The terms are:
1. Profitability = Net Income Sales 2. Efficiency = Sales Total Assets 3. Leverage = Total Assets Shareholders equity, generating #4: 4. Return on Equity (ROE) = Net Income Equity
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The DuPont formula explained above describes a three-component approach. The following describes a five-component approach that decomposes the profitability ratio into interest burden and tax burden so these two additional components can be examined separately. 1. Operating Profit Margin = EBIT Sales 2. Interest Burden = Before Tax Profit Net Income 3. Tax Burden = Net Income Before Tax Profit 4. Leverage = Total Assets Equity 5. Efficiency = Sales Total Assets, generating #6: 6. Return on Equity = Net Income Equity
Growth Rates
Growth rates provide percentage figures to measure growth over time in sales, expenses, profits, assets, or any other entry on the financial statements. Each is the percentage change from one year to the next. It is useful to compare growth rates of one account over different periods, and to compare growth rates for several accounts for the same time period, to uncover the relative changes.
Warnings in Using Financial Ratios
Warning signs are always posted when financial ratio analysis is underway. Several of the warnings follow. Please keep them in mind, because the quality of the conclusions you draw from a ratio analysis is important. They may be the basis of significant business decisions. Comparisons are relative. Understand the reasons behind changes in the trend of a ratio. Economic causes or industry causes may be the driving force rather than causes within your company. Do not get caught in the trap of thinking that differences in absolute dollar amounts are always significant ones. Be aware of the difference between relative comparisons and absolute comparisons, hence the year-to-year percentage changes shown the table above. Seasonal trends must be identified to avoid misinterpretation of the ratios. Some ratios will rise and fall during the year, as a result of seasonal influences that repeat year after year. Therefore, a change in a ratio from one quarter of the year to the next may be normal. Compare ratios using common time periods. Avoid comparing ratios using annual data to those using quarterly or semiannual data, unless adjustments are made. When significant changes in the underlying economic, industry, or company relationships have taken place during the periods of comparison, be extremely wary about drawing conclusions that will be used to plan for the future. When earnings per share figures are calculated and compared, you must remember to make adjustments for changes in the number of shares issued and outstanding from year to year (the number of shares changes when new shares are issued or repurchased, or when a split occurs). The denominator of the earnings-per-share calculation for all periods must contain the number of shares outstanding for the most recent time period. Unless the calculation is made using this number, the earnings-per-share data will be useless. The list of ratios for liquidity, leverage, efficiency, and profitability includes 16 ratios. What happens if many of them show adverse changes from year to year? Be aware
26 that only one weak factor could be the driving force behind every weak ratio, so be careful about considering driving factors and resulting factors. For example, a business with too much borrowing will have too much interest, so all debt ratios will be weak all caused by the same thing. In the DuPont formula, if both efficiency and profitability are constant, and debt is rising, ROE will rise, which should not be interpreted as a strength, but a weakness. If the increase in debt is caused by strongly growing revenue, is it a bad thing or a good thing? It may be either a matter of context provided by other information. These relationships are circular. It is dangerous to consider ratios as independent factors. Ratios often pose questions for further investigation rather than giving you the answer to questions. It is often necessary to look back at the numbers in the income statement and the balance sheet to properly interpret the result.
27 Ratio Interpretation Template (best viewed at 175% magnification or see Template Set.xls)
First, look only at the DuPont Formula ratios Table in rows 121-125. You see the decomposition of ROE, which more-than-tripled from 6.8% to 21.3%. Profitability went up, about three times. Efficiency went up 21%, and leverage went down 19% (reducing leverage is good from a default risk standpoint, but bad from a ROE standpoint because lower profitability means lower ROE). The ROE check is performed in the spreadsheet by computing ROE directly as NP/E, rather than multiplying the three components together, to verify the calculation in row 121. The trend column is the rate of change from 2009 to 2010, showing the relative change for each component. The 216% change in profitability is the key driver of the 212% change in ROE.
Conclusions from the financial ratio analysis of Universal Industries are: The large 212% increase in ROE, as discussed above, caused by very large 212% increase in profitability, helped by a smaller but still impressive 21% change in efficiency, hurt a little by a 19% decline in leverage is impressive but not likely to be sustainable. Profitability increase is powered by operating cost decreases shown in rows 114-15 and reduction of interest expense because of lower debt, confirmed. Unless sustainable, which is unlikely, profit growth may normalize in the future. Growth in revenue in row 128 is lower than growth in profits in rows 129-130, confirming the suspicion that profitability gains are driven by cost reduction rather than either unit volume or unit price increases. Big improvements in times interest earned and full burden coverage ratios may lead to a higher credit-quality rating and a reduction in interest expense. The liquidity situation is mixed; both days in receivables and inventory have improved (fewer days), but days in payables are higher. Collection of receivables may be more efficient and inventory control may be better, but, finance managers may view these metrics differently than production, marketing, and sales managers. More days in payables may mean that Universal is taking better advantage of vendor financing, but, it may be missing discounts for quick payment. 95 96 97 98 99 100 101 102 103 104 105 106 107 108 109 110 111 112 113 114 115 116 117 118 119 120 121 122 123 124 125 126 127 128 129 130 131 A B C D E F G H YEAR 2010 2011 TREND PRELIMINARY INTERPRETATION NUMERATOR DEMONINATOR Liquidity Ratios Current ratio 1.6 1.3 -21% negative, less liquidity current assets current liabilities Quick ratio 1.1 0.8 -21% negative, less liquidity curr assets-inventory current liabilities Days sales in receivables 75.4 56.3 -25% positive, quicker collections receivables revenue/365 days Days cost of sales in inventory 59.9 54.0 -10% positive, faster turnover inventory cost of sales/365 days Days cost of sales in payables 47.6 65.0 37% negative, paying more slowly payables cost of sales/365 days
Leverage Ratios Long-term debt to total capital 57.9% 45.5% -21% positive, less financial risk l-t leases+loans+debt l-t leases+loans+debt+equity Long-term debt to equity 137.4% 83.5% -39% positive, less financial risk l-t leases+loans+debt equity Times interest earned 1.8 3.8 109% positive, better coverage operating profit (EBIT) finance costs Full burden coverage 1.5 3.1 107% positive, better coverage oper profit + lease exp finance costs + (lease exp/[1-tax rate])
Efficiency (Asset-Use) Ratios Fixed asset turnover 1.2 1.4 19% positive, faster turnover revenue total non-current assets Total asset turnover 0.8 1.0 21% positive, faster turnover revenue total assets
Profitability Ratios Gross margin 23.9% 34.9% 46% positive, big improvement gross profit revenue Operating profit margin 6.8% 11.3% 65% positive, bigger improvement operating profit (EBIT) revenue Return on sales 2.7% 8.6% 216% positive, still bigger improvement net profit revenue Return on total assets(ROA) 2.2% 8.5% 283% positive, still bigger improvement net profit total assets Return on equity (ROE) 6.8% 21.2% 212% positive, big improvement net profit equity Return on invested capital (ROIC) 4.7% 9.4% 100% positive, big improvement EBIT*I1-tax rate) total assets
DuPont Formula - ROE 6.8% 21.3% 212% profitability x efficiency x leverage Profitability 2.7% 8.6% 216% positive, big improvement net profit revenue Efficiency 0.8 1.0 21% positive, better turnover revenue total assets Leverage 3.1 2.5 -19% positive, less financial risk total assets equity ROE Check 6.8% 21.2% 212% calculation check to verify row 121 net profit equity Compound Annual Growth Rates Revenues 40.8% 2010 - 2009 2009 Gross profit 105.7% 2010 - 2009 2009 Operating profit (EBIT) 131.9% 2010 - 2009 2009 Total assets 16.0% 2010 - 2009 2009
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Summary
You probably expect these financial ratios to give you answers about financial performance of businesses, but they may pose more questions than answers. It takes lots of practice and seasoning to work comfortably with them.
A quick ratio analysis can be performed by with the DuPont Formula, then adding in the Coverage ratio. The question always comes up, do I need to memorize these ratios? Can I use a cheat sheet? Sure you can use a cheat sheet. But the more you rely on a cheat sheet, the less you know, the more you're going to struggle. You'll see that these ratios come up over and over again. So knowledge of what the terms mean, where the ratio comes from (income statement or balance sheet), if the ratio is made up of numerator or denominator only from the income statement or only from the balance sheet, or one from income statement and one from balance sheet, you should be getting used to all of that. Your color-coded IS/BS Model always guides you in seeing the source of each numerator and each denominator. Notice the three categories for decision-making listed in the IS/BS Model, upper- right corner: WORKING CAPITAL changes spontaneously with revenue ?what levels of ca, cl, s-t loans? CAPITAL BUDGETING ?which projects to accept? FINANCING ?how much debt capacity? Your study of financial ratios should have given you insights into the following questions: What about WORKING CAPITAL POLICY? Is each account trending up or down over time? Is each account tracking with the industry benchmark, or is it higher or lower? What about Fixed Assets (the result of CAPITAL BUDGETING POLICY)? Is turnover rising or falling over time? Is turnover tracking with the industry benchmark, or is it higher or lower? Is there an indication about full or partial use of plant capacity, i.e., efficiency? Can a measure of high or low operating leverage (risk) be discerned? What about FINANCING POLICY? Is interest coverage rising or falling over time? Is interest coverage tracking with the industry benchmark, or it is higher or lower? Is debt capacity being used lightly or heavily? Can a measure of high or low financial leverage be discerned?
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Operating Leverage and Breakeven Levels Breakeven Analysis and Operating Leverage
Published financial statements do not help us very much if we want to distinguish between fixed and variable costs. Nevertheless, such knowledge, if we had it, would be important. You do have fixed and variable cost breakdowns for your own business, so this lesson tells you how important it is and what you need to know about it.
Learning Objectives 1. Understand behavior of variable costs and fixed costs 2. Understand the double-edged sword of operating leverage 3. Understand difference between operating leverage and financial leverage Breakeven Analysis You may want to know, for each year of a business plan, what minimum level of revenue is needed to cover the costs of doing business. In other words, the break-even level of revenue is where you have zero before tax profit, but where all operating and financial expenses are covered. A complete discussion of break-even levels requires understanding of the behavior of fixed costs and variable costs. Some of the expense items listed on the income statement are fixed, that is, they stay at the same level no matter what the revenue is. An example of a fixed cost is rent. When the doors are open for business, rent does not rise or fall as revenue rises or falls. In contrast, other expense items on the income statement are variable costs, that is, they vary up and down as revenue volume varies up and down. An example of that is electricity used to power production machines. Be aware that even fixed costs are variable over the long run, such as an increase in rent when you move to a larger building.
Breakeven Chart
Below is the classic breakeven chart, plotting revenue against fixed cost, variable cost, and total cost. Where the revenue line intersects with the total cost line, profit is zero, defining the breakeven level of revenue.
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Notice that the fixed cost line steps up, indicating that growth in the business leads to increased overhead the variable cost line starts at zero the total costs line sums variable and fixed cost, and starts at the minimum level of fixed cost the revenue line starts at zero and is steeper than the cost lines breakeven is defined as zero profit, where revenue equals total cost
Breakeven Point Revenue Cost Profit Total Cost Loss Variable Cost Fixed Cost Volume (Units)
31 Fixed vs. variable costs
Look at the income statement. Think about the nature of each of these categories. Ask yourself: To what extent are these costs fixed? In the long run, all costs are variable because even salaried employees can be fired, leases can be broken, buildings can be sold, and factories can be expanded. Legacy companies such as airlines use bankruptcy law to reduce fixed cost by rescheduling debt service payments, revising contractual terms of leases, rewriting collective bargaining agreements covering wages, health care, and pensions.
For cost of goods sold, part of it is fixed and part variable. Only knowledge of the specifics behind a particular business will provide an estimate of the breakdown. Foremen's salaries, a portion of assembly-line laborers' salaries, a portion of plant maintenance cost, and a portion of the heat and light bill can all be considered fixed costs. No matter what fluctuations occur in revenue, the business will continue to operate, and expenses will be incurred. The portion of cost of goods sold that is not fixed is variable. That means the materials used in the production process, the electricity used by the machines, and the workers' salaries that are directly related to the volume of production are variable.
General overhead is partly fixed and partly variable. Any personnel subject to layoff constitute variable costs, but there are limits to laying off experienced personnel who may not be available for rehiring when business picks up. It may be short-sighted to attempt to convert fixed costs into variable costs during temporary periods of slow business, because gearing back to full production may cost more than was saved, or may be hampered by not being able to rehire qualified personnel. For example, firing people will cost you in terms of reputation (people will be less willing to work for you and may demand greater compensation to do so), retraining costs and overall morale.
Fixed cost, variable cost, and risk
It can be said that high fixed-cost businesses are more risky than low fixed cost businesses. With high fixed costs, it is easier for a decline in revenue to result in a loss, because fixed costs must be paid even when revenue drops. A business with low fixed costs, however, can suffer a much larger drop in revenue before a loss occurs, because as its revenue fall, most of the costs of operating fall along with them. Therefore, keep in mind the magnification effect behind the relationship of fixed costs to total costs.
32 The box below demonstrates operating leverage. Company A has $200 of fixed costs. As its revenue doubles from one year to the next, its operating profit triples. Company B has no fixed costs, only variable costs. As its revenue doubles from one year to the next, its operating profit doubles the same proportion as the revenue increase. In contrast, Company A had a magnified increase in its operating profit, tripling when revenue doubled. This is how operating leverage works. The presence of fixed costs causes a magnified change in operating profit when revenues change. Dont forget that it works both ways the change in operating profit is magnified on the downside as well as the upside. That is why it involves risk.
Summary
Operating leverage is an under-appreciated aspect of financial management. Much more attention is paid to financial leverage, which is a big oversight.
The significance of operating leverage is, the greater the proportion of fixed operating costs to operating total costs, the greater will be the change in EBIT when sales change. With General Motors having very heavy fixed costs because of its labor contracts, a given percentage of falling sales creates a magnified fall in EBIT. If 100% of costs were variable, they would rise and fall in proportion to rises and falls in sales.
Leverage is a double-edged sword. When it cuts with you, its good because a given percentage change in sales generates a magnified percentage change in profit. When it cuts against you, the fall in sales, percentage-wise, generates a magnified drop in profit.
Most companies have more control over their financial leverage than over their operating leverage. The fixed cost-variable cost relationship is determined to a great extent by the nature of the industry. Modern auto manufacturers have sophisticated plants, which imply high fixed cost. If they assembled the vehicles under a canvas shed behind a barn, using itinerant labor and hand tools, hardly any of their costs would be fixed.
Operating Leverage Company A Company B YEAR 1 YEAR 2 YEAR 1 YEAR 2 Revenue 1000 2000 1000 2000 Fixed cost 200 200 0 0 Variable cost 600 1200 800 1600 Operating profit 200 600 200 400
Learning Objectives 1. Use financial ratios as the basis of financial statement forecasts 2. Know that the forecast is driven by the anticipated growth rate in sales 3. Understand why and how the forecast reveals how much external financing is needed to sustain the business plan portrayed in the forecast 4. Know difference between accounts that change spontaneously with sales and those that change only when policy changes 5. Learn how to perform and interpret financial statement forecast in an Excel spreadsheet
Percentage-of-Sales Forecasting of Financial Statements & Determining External Financing Needed
This presentation draws on the previously discussed concept of sources and uses of funds: The number at the bottom of the income statement, profit reinvested in the business, is a source of funds (as long it is a positive number not a loss). It is added into the equity side of the balance sheetthe sources of funds side, along with increases in current liabilities, another source of funds. Increases in the asset accounts, current assets and long-term assets, are uses of funds, those needed to grow the business. Then the two sides are totaled, with the plug figure making up the difference, where uses exceed sources, showing external financing required In the event that sources exceed uses, which may occur when a business is not growing (a cash cow), the excess goes into cash. Thats why businesses that are not growing, and are not increasing their assets, but remain profitable, are called cash cows.
This chapter presents two ways to perform percentage of sales forecasting. 1. First, a short-form forecasting approach is designed to explain the concept and methodology. It is directed a forecasting beginners who need to start with the basics; it is more for pedagogy than it is for applications, because it is pared down and simplified. 2. Then, a long-form forecasting approach is presented which has the depth and complexity of a full-blown forecasting model.
The Short-Form Forecasting Model
The template below shows a short-form forecasting model for Leahy Bread Company, a chain of bakeries with 1,027 locations. Notice 11 rows of income statement data followed by 13 rows of income statement data, ending with a single row labeled External Financing Needed. In the three left-hand columns, you see two years of history, 2010 and 2011. In the three right-hand columns, you see a single forecast year, 2012. Everything is on a single page of 32 rows and 7 columns, so you can see it all at once, without flipping pages back-and-forth or scrolling through Excel. (By comparison, the Long-Form Forecasting Model has 131 rows and 18 columns.)
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Leahy Bread Company (LBC) is growing and building new bakeries. Revenues in 2011 were $828,971,000, with Net Income of $42,011,000, a return on sales of 6%, down from 8% in 2010. It has a term loan of $241,940,000, a big increase from the previous year; much of it used to build new stores as Property, Plant and Equipment grew to $495,000,000 in 2011, an increase of $226,191,000 from 2010, a 84% increase.
The Financial Director wants to know how much external financing will be needed, either debt or equity, as of the end of 2012, so he uses the Short-Form Forecasting Model to get a quick forecast. In Columns D and E, he enters the assumptions required for the forecast based on 2011 historical results. He could use averages of both 2010 and 2011 instead, or he could adjust any of the inputs based on his own judgment and knowledge of the business and economic conditions. This is how he did it: 1. The forecast is driven by a planned 20% increase in revenues, entered in cell E5. That percentage increase is high because of revenue from recently built stores. 2. The ratio of cost of goods sold to revenue was 75.8% in 2011, but he lowers it to 70% based on expected cost decreases for raw materials. 3. Depreciation is not driven by revenue as was cost of goods sold. Instead, it is driven by the amount of depreciable assets, plant, property, and equipment. The assumption is that depreciation will be 12.5% of PPE, entered as a number in E7. 4. E8 gets the ratio of g&a expense to revenue, C8 divided by C5, 7.7%, but this is increased to 10% to allow for more advertising. 5. Interest expense in row 11 is 7% of the expected term loan outstanding during 2012. New financing is unknown until the finance director knows if more borrowing 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 A B C D E F G (000) omitted 2010 2011 2012 history history forecast assumptions inputs formula forecast Number of Bakeries 877 1,027 INCOME STATEMENTS: Revenue 640,275 828,971 target growth rate 20.0% =C5*(1+E5) 994,765 Cost of Goods Sold 474,796 628,534 ratio: cgs/revenue 70.0% =E6*G5 696,336 Depreciation 33,011 44,166 $: 12.5% of ppe 61,875 =0.125*C23 61,875 General and Administrative 50,240 63,502 ratio: g&a/revenue 10.0% =E8*G5 99,477 Total Expenses 558,047 736,202 =G6+G7+G8 857,687 Operating Profit (EBIT) 82,228 92,769 =G5-G9 137,078 Interest Expense 3,246 16,931 7% of 2012 term loan =0.07*G8 16,936 Pretax Profit 78,982 75,838 =G10-G11 120,142 Tax 29,995 33,827 ratio: tax/pretax profit 44.6% E12*G12 53,589 Net Income 48,987 42,011 G12-G13 66,554
BALANCE SHEETS: 2010 2011 Cash and Short Term Investments 60,651 72,122 $: same as 2010 =C18 72,122 Accounts Receivable 25,158 30,919 ratio: rec/rev per day 30.0 =E19*(G5/365) 81,762 Inventory 7,358 8,714 ratio: inv/cgs per day 5.1 =E20*(G6/365) 9,654 Prepaid Expenses 9,607 15,863 $: 12,400 given given, no formula 12,400 Current Assets 102,774 127,618 =sum(G18.G21) 175,938 Net Property, Plant and Equipment 268,809 495,000 $: 640,000 given given, no formula 640,000 Total Assets 371,583 622,618 =sum(G22.G23) 815,938 Accounts Payable 8,222 10,842 ratio: pay/cgs per day 6.30 =E26*(G6/365) 12,012 Current Liabilities 8,222 10,842 =g26 12,012 Term Loan 46,383 241,940 term loan in place given, no formula 241,940 Total Liabilities 54,605 252,782 =G27+G28 253,952 Stockholder's Equity 316,978 369,836 previous+net income =C30+G14 436,390 Total Liabilities & Equity 371,583 622,618 =G29+G30 690,341 EXTERNAL FINANCING NEEDED EFN result =G24-G31 125,596
35 will occur. He does not know if more borrowing will occur until this forecast of EFN is completed. 6. The income tax rate in E13 is calculated by dividing C13 by C12. 7. Cash and short term investments in row 18 does not change. 8. E19 gets a much higher ratio of receivables to revenue per day instead of 13.6 days in 2011. Increased catering and more commercial accounts will cause a longer collection period, 30 days. 9. Inventory is perishable and turns rapidly, so E20 gets the ratio of inventory to cost of goods sold per day of 5.1 days. 10. Prepaid expenses is a given, 12,400 in G21, because it is expected to fall to this level at the end of 2012. 11. Property, plant, and equipment will increase from 495,000 at the end of 2011 to 640,000 at the end of 2012, so 640,000 is entered in G23. 12. Payables are based on the 2011 level of 6.3 days. 13. The term loan remains at 241,940, so that amount goes into G28. 14. Stockholders equity is the sum of the previous years amount plus the net income for the current year, so F30 gets the sum of C30 plus G14. If dividends are paid in cash, F14 must be reduced by the amount of the dividends. 15. The final step is deducting the total of USES of FUNDS (G24) from SOURCES OF FUNDS (G31) to get EXTERNAL FINANCING NEEDED. Total Assets are the total of funds used in the business the amount that must be invested to generate the revenue on the income statement. Total Liabilities and Equity is the sources of funds, where the money comes from. In this forecast, USES are $125,596 higher than SOURCES, meaning that that much money must be raised from either debt or equity financing by the end of 2012.
You just witnessed the process of making a forecast, from beginning to end. Data from the past was used in combination with judgment about the future based on knowing the business. Realize that the bullet points in the step-by-step process listed above can be categorized in two ways: 1. Those that are based on ratios, such as rows 5 (revenue), 6 (cost of goods sold), 8 (general and administrative expense), 13 (tax), 19 (receivables), 20 (inventory), and 26, (payables). For each of these entries, the input in Column E either has a ratio based on historical experience or it is overridden by expert judgment; then a formula in Column F does the calculations, using the input in Column E. Financial analysts refer to these entries as spontaneously changing as revenues change; they are revenue driven. 2. Rows 7, 11, 18, 21, 23 and 28 do not have inputs in Column E because they are not driven by historical ratios (or revised based on expert judgment) used in the formulas in Column F, but entered directly in Column F as amounts of money. These entries do not change spontaneously with revenues, but must be determined by managers.
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The Long-Form Forecasting Model (LFFM)
The forecasting process results in projected income statements for the next five years, 2012-2016. Forecast for shorter or longer periods by deleting or adding columns or leaving them blank.
Starting with the first row of the income statement, revenue, and go down row-by-row, entering your educated guess in each of the assumption cells, based on historical ratios and intentions about the future. Then, you do he same thing for the balance sheet, working row-by-row. The forecasts are in nominal terms, with inflation already imbedded in the forecasted growth rate.
You can control the assumption for each of the rows and each of the time periods rather than using the same one across all periods as some forecasting models do. Also, notice that the number of accounts in the financial statements is extensive - rows labeled other lets you customize to some extent, as long as the formulas do what you intend them to do. Always be aware of what the formulas in the forecast cells, Columns M.Q, are doing with the assumptions you enter in Columns H.L.
(some columns not shown, best viewed at 150% or 175% magnification, go to Template Set.xls for all-column view)
Step-by-Step Forecast of Income Statement
1. Enter data from historical income statements in Columns B-F. The labels in Column A in the Long-Form Forecasting Model may not exactly match the labels in the statements you are working from, so it will be necessary to fit the source data to the model; use catch-all Other category as necessary. Be careful not to disturb 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 A E F G H I J K L M N O INCOME STATEMENT .forecast assumptions.. .forecast.. PERIOD -1 0 1 2 3 4 5 1 2 3 JANUARY 1-DECEMBER 31 2010 2011 2012 2013 2014 2015 2016 2012 2013 2014 0.5 Revenue 869.5 1224.0 revenue growth rate 10.0% 12.0% 12.0% 12.0% 8.0% 1346.4 1508.0 1688.9 Cost of sales (661.9) (797.0) cost of sales/revenue 66.0% 67.0% 64.0% 63.0% 63.0% (888.6) (1010.3) (1080.9) Gross profit 207.6 427.0 457.8 497.6 608.0 Other operating income 6.7 10.1 estimated amount 10.1 10.1 10.1 10.1 10.1 10.1 10.1 10.1 Distribution costs (52.7) (108.3) cost/revenue 8.8% 8.0% 7.2% 6.5% 6.0% (119.1) (120.6) (121.6) Administrative costs (84.4) (149.1) cost/revenue 12.2% 12.2% 12.2% 12.2% 12.2% (164.0) (184.0) (206.0) Depreciation & amortization expense 0.0 0.0 % of ppe 7.5% 7.5% 7.5% 7.5% 7.5% (65.4) (65.4) (65.4) Other operating costs (17.7) (23.4) cost/revenue 1.9% 1.9% 1.9% 1.9% 1.9% (25.7) (28.7) (32.1) Restructuring costs 0.0 (18.3) estimated amount 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 Total operating costs (810.0) (1086.0) (1252.8) (1398.9) (1496.0) Profit from operations (EBIT) 59.5 138.0 93.6 109.0 192.9 Interest, financing expense (33.0) (36.7) 0.0 0.0 0.0 Income from investments 1.7 15.7 estimated amount 5.0 5.0 5.0 5.0 5.0 5.0 5.0 5.0 Disposal of operations 0.0 8.5 estimated amount 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 Profit before tax 28.2 125.5 98.6 114.0 197.9 Income tax (4.4) (19.6) average tax rate 15.6% 15.6% 15.6% 15.6% 15.6% (15.4) (17.8) (30.9) Profit after tax 23.8 105.9 83.2 96.2 167.0 Minority interest (0.1) (0.6) 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 Other 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 Net profit 23.7 105.3 83.2 96.2 167.0 Dividends (8.0) (5.0) payout ratio 10.0% 15.0% 20.0% 25.0% 25.0% (8.3) (14.4) (33.4) Other 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 Reinvested in the business 15.7 100.3 74.8 81.8 133.6
37 formulas, entering data only in blank data-entry cells. Remember that income statement entries represent flows during the time period. 2. Estimate revenue growth H8.L8 as a percentage for each year of the five-year planning periods beyond the base year in Column F. The growth rates set here combine unit and price level increases into a single growth rate. 3. Enter percentages for each of the operating expense items for each time period: cost of sales in H9.L9, distribution costs in H12.L12, and administrative costs in I13.L13. Base them on historical ratios and judgment on their likely behavior in the future. The formulas in the template multiply your assumed ratio by the revenue for that period, the essence of the percentage-of-sales method of forecasting. A complication lies in the assumption that all operating costs are variable with respect to revenue, which simplifies reality. The income statement uses the format of published financial statements, which do not break out fixed and variable costs separately. 4. Other operating income (if any) H11.L11 is entered as a number, not a ratio; no formula is involved. The number entered in the assumption cell is entered in the forecast cell. 5. Depreciation and amortization expense in H14.L14 is forecasted as a percentage of prior year depreciable fixed assets and can be derived from information in the footnotes to published financial statements. Often, depreciation expense is included in cost of goods sold and other expense accounts, and is not shown as a separate item; in that case leave H14.L14 blank. 6. Other operating costs in H15.L15 are left blank unless this category is needed for other items that are forecasted as a percentage of revenue. 7. Restructuring costs, if any, are entered in H16.L16 as a number. 8. Entering interest, financing expense in H19.L19 is challenging. Until the forecast is complete, the amount of external financing needed is not known. Since the amount of financing is not known, interest expense cannot be known either. For existing loans and debt that will not be repaid during the forecast period, enter interest expense for that debt; for existing loans and debt that will be repaid during the forecast period, enter zero. Enter them as nominal numbers. 9. Income from investments in H20.L20, disposal of operations in H21.L21, H25.L25 minority interest, and H26.L26 other are entered as numbers if these categories are relevant. No formulas are involved; the amount entered in the forecast cell is transferred to the forecast cell. 10. The income tax rate in H23.L23 is based on historical income tax rates and is entered as a percentage. 11. The dividend payout ratio in H28.L28 is based on historical dividend payout ratios. If the dividend is given as a number, convert it into a ratio.
To understand how Excel calculates the forecast, put your cursor on the forecasted cells, Columns M.Q for each row. You will see how the assumption is used in a formula to calculate the forecasted item. Please take special care to recall, just as in the Short- Form Forecasting Model, that some line items forecast with an assumed ratio, others forecast with a number. Where the assumption cell contains a ratio, a formula in the forecast produces the result. Where the assumption cell contains a number, that number is transferred to the forecast cell.
For Cells B33.F39, enter data if they are available.
38
Step-by-Step Forecast of Balance Sheet Forecast
(some columns not shown, best viewed at 150% or 175% magnification, go to Template Set.xls for all-column view)
The forecasted balance sheets are prepared by entering a reasonable estimate of the projected assumption in each row, just as you did with the income statement forecast. Remember that balance sheet entries represent end-of-period balances.
Some balance sheet accounts change spontaneously with changes in revenue; others change only as a result of policies decided by the managers of the business. It is important to distinguish between those accounts that change spontaneously, such as accounts receivable inventory accounts payable 41 42 43 44 45 46 47 48 49 50 51 52 53 54 55 56 57 58 59 60 61 62 63 64 65 66 67 68 69 70 71 72 73 74 75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 A E F G H I J K L M N O BALANCE SHEET .forecast assumptions.. .forecast.. PERIOD -1 0 1 2 3 4 5 1 2 3 AS OF DECEMBER 31 2010 2011 2012 2013 2014 2015 2016 2012 2013 2014 ASSETS Current assets: Cash & equivalents 1.2 5.6 % of revenue 0.5% 0.5% 0.5% 0.5% 0.5% 6.2 6.9 7.7 Investments 29.7 37.2 estimated amount 37.2 37.2 37.2 27.2 27.2 37.2 37.2 37.2 Trade receivables 179.5 188.9 days revenues 50.0 52.0 54.0 56.0 58.0 184.4 214.8 249.9 Inventory 108.6 117.9 days cost of sales 50 55 55 60 60 121.7 152.2 162.9 Other 0.0 0.0 0 0 0 0 0 0.0 0.0 0.0 Total current assets 319.0 349.6 349.5 411.2 457.7 Non-current assets: Property, plant & equipment-gross 600.4 722.5 estimated capex 150.0 0.0 0.0 150.0 0.0 872.5 872.5 872.5 Accumulated deprec. & amort. (33.6) (62.9) by formula (128.3) (193.8) (259.2) Property, plant & equipment-net 566.8 659.6 744.2 678.7 613.3 Investment property 11.4 12.0 12.0 12.0 12.0 12.0 12.0 12.0 12.0 12.0 Goodwill 0.1 0.6 0.6 0.6 0.5 0.5 0.4 0.6 0.6 0.5 Other 1 167.1 213.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 Other 2 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 Total non-current assets 745.4 885.2 756.8 691.3 625.8 Total assets 1064.4 1234.8 1106.3 1102.5 1083.5 LIABILITIES AND EQUITY Current liabilities: Trade & other payables 86.3 141.9 days cost of sales 50 55 60 60 60 121.7 152.2 177.7 Retirement benefit obligation 4.5 3.8 estimated amount 4.0 4.0 4.0 4.0 4.0 4.0 4.0 4.0 Tax liabilities 2.0 8.2 %age of curr inc tax 40.0% 40.0% 40.0% 40.0% 40.0% 6.2 7.1 12.4 Leases due in 1 year 1.5 1.5 1.5 1.5 1.5 1.5 1.5 1.5 1.5 1.5 Loans, debt due in 1 year 102.5 111.9 112.0 112.0 112.0 112.0 112.0 112.0 112.0 112.0 Other 2.0 8.6 8.6 8.6 8.6 8.6 8.6 8.6 8.6 8.6 Total current liabilities 198.8 275.9 254.0 285.5 316.1 Non-current liabilities: Retirement benefit obligation 34.0 30.2 estimated amount 30.2 30.2 30.2 30.2 30.2 30.2 30.2 30.2 Deferred tax liabilities 6.4 15.4 estimated amount 15.4 15.4 15.4 15.4 15.4 15.4 15.4 15.4 Finance leases due after 1 year 1.2 0.9 1.0 1.0 1.0 1.0 1.0 1.0 1.0 1.0 Loans, debts due after 1 year 474.9 413.1 413.0 413.0 413.0 413.0 413.0 413.0 413.0 413.0 Other 0.0 0.0 estimated amount 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 Total non-current liabilities 516.5 459.6 459.6 459.6 459.6 Total liabilities 715.3 735.5 713.6 745.1 775.7 Stockholder's equity: Preferred stock 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 Common stock 120.0 120.0 120.0 120.0 120.0 120.0 120.0 120.0 120.0 120.0 Paid-in surplus 32.1 32.9 estimated amount 32.9 32.9 32.9 32.9 32.9 32.9 32.9 32.9 Other 35.1 83.5 estimated amount 83.5 83.5 83.5 83.5 83.5 83.5 83.5 83.5 Retained earnings 159.3 259.7 prev r/e + curr reinv prof 334.5 416.3 550.0 Total equity 346.5 496.1 570.9 652.7 786.4 Minority interest 2.6 3.2 Total liabilities & equity 1064.4 1234.8 1284.5 1397.8 1562.1
39 and those that change only when management decides to change them, by a change in policy, by an actual decision, such as: fixed assets
(Some analysts increase fixed assets in proportion to increases in revenues. This may be an unwise short cut. It fails to take excess capacity into account. It also fails to consider that fixed assets are not necessarily scalable to revenue increases.) short-term borrowing long-term borrowing dividend payout equity repurchase equity issue
Remember that the net working capital accounts of receivables, inventory, and payables are determined by two inputs: receivables is calculated by revenue per day x number of days of revenues in receivables (collection period) revenue is a spontaneous change, but the days revenues in receivables is a policy issue determined by managers if they want to tighten credit terms, they reduce the number of days, and vice versa. inventory is calculated by cost of goods sold per day x number of days of cost of goods sold in inventory cost of goods sold changes when revenue changes, but the number of days of cost of goods sold is a policy decision that is adjusted by managers. payables is calculated by cost of goods sold per day x number of days of payables in cost of goods sold the number of days of payables is a policy decision that is adjusted by managers if they pay their suppliers quickly the number of days is lower.
1. For H47.L47, estimate the minimum cash balance based on the historical trend. For most businesses, cash is not driven by sales, so this forecast is a rough guestimate. Some analysts prefer to enter a number amount in H47.L47, and change the formulas in M47.Q47 to accept those numbers. Investments in H48.L48 is entered as an amount. 2. Set trade receivables in H49.L49 as the number of days revenue in receivables. As just stated above, the number of days is a policy matter - it can be smaller or larger depending on how generous managers want to be in extending credit to customers. But, once the number of days is set, accounts receivable changes spontaneously with revenues. For example, a 60-day collection period, favored by the marketing department, means that the firm must invest twice as much in receivables compared to a 30-day collection period. No provision for uncollectible receivables is made in this forecast. 3. Set inventory in H50.L50 as the number of days costs of sales in inventory. It can rise or fall throughout the period, depending on judgments about competitive conditions, breadth of product lines, the production cycle, and other relevant factors. But once the number of days is set, inventory behaves spontaneously in response to changes in revenue levels. 4. Use other in H51.L51 if necessary, entering a number which is transferred to the forecast cell. 5. All non-current asset assumptions, except accumulated depreciation in H55.L55, are entered as numbers and are transferred directly to the forecast cells. They do not change spontaneously when revenue changes; they are determined by engineering estimates comparing existing capacity with forecasted capacity. Many
40 businesses have excess plant capacity and are able to increase production without buying new plant, property and equipment. Care should be taken so that production levels implied by revenue do not exceed plant capacity. Increases in fixed assets should be made only for revenue increases requiring production that exceeds existing capacity. When revenue increases solely because of price increases, no additional plant capacity is needed. 6. Accumulated depreciation is calculated automatically; no entry is required. Formulas take depreciation expense from row 14 on the income statement to adjust accumulation depreciation on row 55 of the balance sheet. When the source financial statements do not specify depreciation expense, but include it with cost of goods sold and other expense items, the forecast of depreciation expense (IS) and accumulated depreciation (BS) will not be accurate. 7. H57.H60 contain numerical assumptions for investment property, goodwill, and other. Leave them blank if not relevant. 8. Trade payables in H66.L66 is entered as the number of days cost of sales; it changes spontaneously with sales. For example, a 10-day payment period may mean that the firm can take advantage of discounts offered by suppliers if they receive payment quickly. But, since accounts payable is a source of funds (supplier financing), as the payment period falls, the firm must find other sources of financing if it reduces its payment period. Financing not provided by trade credit must be provided elsewhere. 9. Retirement benefit obligation, if known, is entered as a number in H67.L67. 10. Tax liabilities in H68.L68 is entered as a percentage of income tax on the income statement. It represents income tax due to the government. 11. Leases dues in one year in H69.L69 and loans due in one year in H70.L70 are entered as numbers indicating the outstanding amount at the end of the time period. These numbers can be entered as zeroes, consistent with their status as current liabilities, due in one year. After external financing needed is calculated, financial managers will decide how much of that external financing need can be provided by short term leases and borrowing. 12. Retirement benefit obligation in H74.L74 and deferred tax liabilities in H75.L75 are entered as numbers, if known and relevant. 13. Leases and loans in H76.L76 and H77.L77 include only items that are outstanding in the base year and will not be repaid in the forecast years. Reduce the lease amount by annual payments scheduled. Reduce the loan amount by annual principal payments scheduled. 14. Other in H78.L78, if any, is entered as a number. 15. Entries in H82.L85 for preferred stock, common stock, paid-in-surplus, and other are entered as numbers from the base year. New financing should not be entered because it depends on the external financing needed, the result of the forecast, and decisions by the managers and their advisers. 16. Add Reinvested in the business balance from the income statement forecasts to equity on the balance sheet, linking the income statements with the balance sheets. 17. Retained earnings in H86.L86 needs no entry. It is calculated automatically by summing the previous period retained earnings (row 86) from the balance sheet and current period reinvested in the business (row 30) from the income statement. 18. Enter minority interest in H88.L88 if known and relevant. 19. Examine the total assets (row 62) and the total liability plus equity (row 89) of the balance sheet. Notice that the two sides do not balance. Usually, in a growing business, the asset side (uses of funds) will show a higher amount than the liability plus equity side (sources of funds), which means that external financing (EFN) is
41 needed. Row 91 subtracts row 62 from row 89, calculating EFN. A positive number for EFN indicates a shortage of uses over sources, telling you that external financing is needed and must be arranged. A negative number of EFN indicates a surplus of sources over uses, telling you that no external financing is needed and that the business will generate cash. IMPORTANT: Since balance sheets cumulate end-of-period balances, the EFN numbers in cells M91.Q91 must be interpreted as cumulative, not additive. This vital is discussed below.
To understand how Excel calculates the forecast, put your cursor on the forecasted cells, Columns M.Q for each row. You will see how the assumption is used in a formula to calculate the forecasted item. Please take special care to recall, just as in the Short- Form Forecasting Model, that some line items forecast with an assumed ratio, others forecast with a number. Where the assumption cell contains a ratio, a formula in the forecast produces the result. Where the assumption cell contains a number, that number is transferred to the forecast cell.
Circularity Between Interest Expense (IS) & External Financing Needed (BS)
The financial statements forecasted above must be considered as preliminary; they are incomplete. Financing cost, as shown on the projected income statement, measures only the interest on the existing debt. If external financing need is raised from debt sources, financing cost rises. This causes profit after tax to fall, which in turn causes external financing needed to rise. Refer to the IS/BS Model to visualize what happens because the income statement and balance sheet are linked. For example, you assume that all external financing will be accomplished with long-term debt with an interest rate of 9%. Finance cost on the income statement is adjusted to reflect this. But, as finance cost rises, profit falls. Since profit is added to equity, equity also falls. Falling equity, a source of funds, causes external financing to rise. This circularity cannot be avoided; it is inherent in the process of preparing forecasted financial statements. Since the forecast is based on estimates that have a degree of error in them, many analysts do not refine the results, accepting this first iteration of the forecast as a reasonable estimate of external financing needed.
I rely on what is called the cavalier approach to forecasting. It works because the forecast usually gives a meat-axe rather than a scalpel-cut result, so why pretend otherwise. If the purpose of the forecast is to tell you how much external financing is required, the cavalier approach gets you close enough.
42
Interpreting External Financing Needed (EFN)
The chart above illustrates the behavior of financing needs over time. As revenue increases, the need for both fixed assets and net working capital increases, with the magnitudes shown by the slope of the lines. Part of net working capital is permanent, i.e., its minimum level., stepping up each year as plan, property and equipment increases to support growing revenue. Another part is temporary, i.e., it cycles up and down according to seasonal trends. (With no seasonal trend, the cyclical up-down lines on the chart would not exist.) Permanent funding is required for permanent increases in assets needed as the business grows, and temporary financing is suitable for temporary needs. Temporary borrowing is revolving credit that is used when needed, and repaid when not needed.
A forecast estimated these external financing needs of Company X for 2007-2011, as below:
Interpret the figures for external financing needed as cumulative, meaning the amount of financing needed through the end of that period. By the end of 2007, this company needs 178.2 million dollars of external financing, if it operates at the revenue growth levels projected. By the end of 2008, external financing has grown to 295.2, an increase of 117.0. By the end of forecast period in 2011, the external financing need has become 743.2 suggesting that about three-quarters of a billion dollars are needed to support the growth plan where revenue increases.
Seasonal (Short-Term) vs. Permanent (Long-Term) Financing
You can calculate a one-year forecast with monthly periods. The pattern of external financing needed on this monthly forecast can be used to tell whether you will need seasonal short-term loans or permanent long-term borrowing
Seasonal borrowing is temporary because you use it to build inventory and carry accounts receivable for only that part of the year when your business operates at peak levels. Called short-term inherently self-liquidating (STISL) loans, the proceeds of the loan are used to buy inventory. When that inventory is sold, accounts receivable increase; eventually, those receivables are collected and the cash received is used to repay the loan. Because both
43 inventory and receivables decrease at the end of the peak selling season, the financing requirement is temporary; it is repaid as receivables are collected and cash becomes available. This type of loan is called a balance sheet loan because the source of repayment comes from the balance sheet as current assets cycle from inventory to receivables to cash.
Permanent borrowing is not repaid within one year. Usually, the source of repayment comes from profits, so this type of loan is called an income statement loan.
Borrowing requirements may be temporary or permanent. The first cash flow pattern below shows a deficit in January through April, followed by a surplus in May through August, and again a deficit in September through December. The May through August surplus shows that the loan is zero during these months. Therefore, it is a true temporary, inherently self- liquidating working capital line of credit, cleaned up during part of the year, and drawn on as peak needs build up again. Notice that the loan increases from September through January, assuming that the annual seasonal cycle repeats. It peaks at 50, then, falls as the loan is repaid at a rate of 10 each month until May when all of it is repaid. All borrowing shown here is STISL; borrow when you need it - repay when you do not need it.
If deficits of varying amounts are shown for each month, the interpretation of financing needs becomes more complex. In the second cash flow pattern below, you see cash flow deficits rising, indicating a seasonal pattern. But, because the deficits never shift to surpluses, and the deficits have a minimum level of 30, this defines the minimum level of borrowing, the borrowing that is needed every month, i.e., permanent borrowing. When permanent borrowing of 30 is in place, it is shown as an inflow, netting out to the STISL loan cycling up and down, leaving zero balances in the months when it is cleaned up.
The third cash flow pattern below indicates that cash requirements are steadily increasing because of secular growth, and that permanent financing is required.
Mismatch of Intra-Period Cash Flows
The forecasts above were structured to give results for the end of each month. This approach assumes that inflows and outflows of cash are evenly matched throughout the month. Instead, assume that all of the outflows occur in the first five days of the month, and all of inflows occur in the last 10 days of the month. Even though you have a forecast telling you that no borrowing is necessary, you will not have the money to pay your bills during the first five days because the money will not start to flow for at least 10 more days.
To avoid creating a forecast that gives false signals of security, be aware of the timing of the intra-month cash flows. It is for this reason that some businesses budget cash on a daily basis. You can solve the mismatch problem by having the ending date of the forecast
JAN FEB MAR APR MAY JUN JUL AUG SEP OCT NOV DEC Surplus (Deficit) -50 -40 -30 -20 10 20 30 40 -10 -20 -30 -40
JAN FEB MAR APR MAY JUN JUL AUG SEP OCT NOV DEC Surplus (Deficit) -50 -40 -30 -30 -30 -30 -30 -30 -30 -30 -40 -40 Permanent f ianncing 30 30 30 30 30 30 30 30 30 30 30 30 STISL -20 -10 0 0 0 0 0 0 0 0 -10 -10
JAN FEB MAR APR MAY JUN JUL AUG SEP OCT NOV DEC Surplus (Deficit) -10 -20 -30 -40 -40 -45 -50 -55 -60 -60 -65 -70
44 coincide with the low ebb of cash for that month. Pick the date when your excess of outflows over inflows is at its greatest level.
Horizontal totals
Be careful about adding across the lines of a spreadsheet to derive annual totals. You can do this for the rows in the income statement, because they are flows occurring during a time period. Do not do it for balance sheet lines, because these figures are end-of-period balances, already on a cumulative basis - they are not additive. Make a mental note about this!
Forecasting and inflation
Revenue in dollars is the product of units sold (volume) multiplied by the price of each unit. It is important to realize what proportion of a revenue increase comes from unit revenue (real), and what comes from change in the unit price (nominal). In forecasting income statements and balance sheet items, the forecast should be made in nominal terms. Revenue and expenses are stated in nominal dollars because this is the amount of money that flows in and out of the business. In the balance sheet, accounts receivable, inventory, and accounts payable are stated nominally because they reflect the prevailing prices of goods and services bought and sold. But fixed assets is another story because only real increases in revenue exhausts excess fixed asset capacity. Therefore, when forecasting fixed assets, be careful to consider only the impact of real revenue increases. If revenue increases 10% per year, and the whole increase comes from price inflation, unit production of goods does not change so plant capacity does not have to be increased.
Summary
A financial statement forecast that increases all accounts by the projected growth rate in sales is wrong-headed because Receivables, inventory, and payables spontaneously change as sales changes i.e., the are driven by sales Most other accounts are policy-determined they are not driven directly by sales Property, plant and equipment is not necessarily going to increase when sales increases, if excess capacity is available, or if sales increases are inflationary with no rise in unit sales
A major purpose of a financial statement forecast is to find out how much external financing (EFN) is required to support the business plan. It is the plug figure that forces a balance between sources and uses of funds. At this point in the course, no decision is made about how to provide EFN, from short-term borrowing, long-term debt, or equity sources.
When interpreting the EFN row of a forecast, make sure to examine the sign carefully. When uses of funds exceed sources, EFN is needed. When sources exceed uses, EFN may be stated as a negative number, which is interpreted as a surplus. In this instance, the plug is to cash.
When interpreting the EFN row of a forecast, remember that the figures come from balance sheets and are cumulative never add them. When EFN rises from one period to the next, it means that EFN is increased by the difference between the two amounts.
45 When EFN falls from one period to the next, it means that EFN is reduced by the difference between the two amounts. The EFN in the final period tells you the total EFN for the entire planning period.
Now that you know now to forecast, a look at this deceptively simple diagram will bring home an important point about the relationship between revenue (sales) growth and the balance sheet. You will soon learn that an income statement all by itself does not contain enough metrics to judge the performance of a business the balance sheet is needed too. You will learn that Free Cash Flow is a better performance metric than Net Income, because it combines income statement and balance sheet information, i.e.,
FREE CASH FLOW = EBIT TAX + DEP +/- CHANGE IN NWC +/- CHANGE IN PPE
The first three terms come from the income statement (EBIT, tax, depreciation); the last two terms come from the balance sheet (net working capital, property, plant, equipment). The analysis below is a striking picture of external financing needs and their drivers that demonstrates how the cash flows in a business operate.
This diagram looks like a balance sheet but it is more than that. Know that the label in row 4 says revenue change because it could be an increase or decease.
Assets that grow spontaneously as revenue grows are expressed as percentages of revenues, as shown in Cells D10 and I10. As long as the days revenues in receivables, inventory, and payables are not changed, these ratios can be expressed as percentages of revenues. Think of it as one dollar of additional revenue requiring 27.3 cents of additional receivables + inventory, and 11 cents of additional payables plus other accruals. The fixed assets, property, plant and equipment require more analysis. It is possible for revenue to growth with no increase in fixed assets if excess capacity in PPE is available. Therefore, fixed asset increase should never be expressed 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 A B C D E F G H I FOR EACH $1 CHANGE IN REVENUE: Assumptions: revenue 2694 net profit margin 1.6% CHANGE IN ASSETS (USES OF FUNDS) CHANGE IN LIABILITIES+EQUITY (SOURCES OF FUNDS) cents cents CURRENT ASSETS CURRENT LIABILITIES RECEIVABLES 317 PAYABLES 256 INVENTORY 418 OTHER ACCRUALS 39 CA/SALES 27.3 CL/SALES 11.0 FIXED ASSETS LONG-TERM DEBT 0 PLANT PROPERTY EQUITY EQUIPMENT INCR IN RET EARN/SALES 1.6 FA/SALES 0.0 TOTAL FORECASTED SOURCES 12.6 EXTERNAL FINANCING NEEDED 14.7
TOTAL FORECASTED USES 27.3 ADJUSTED TOTAL FORECASTED SOURCES 27.3
46 as a percentage of revenue without considering engineers estimates of actual PPE increases in dollars, which are then converted to a percentage, entered in D13.D15, although this example has no PPE increase. Long-term debt is not driven by revenue growth. Instead, it is a conscious decision. Therefore, enter 0 cents in I12. Equity grows with growing revenue via net profit. Therefore, the net profit margin shows the sources of funds generated this way, 1.6 cents entered in I15. D21 shows cents of total uses of funds (increases in asset accounts per dollar of revenue increase). I17 shows 12.6 cents of total sources (increases in liability and equity accounts per dollar of revenue increase). Then, I19 subtracts total sources from total uses to calculate 14.7 cents External Funds Needed. A positive number tells you that sources are less than uses, requiring external financing. A negative number tells you that sources exceed uses, providing a surplus, with no need for external financing. I21 is the sum of total sources in I17 and external financing needed in I19 to get the new total of sources, balancing with total uses in D21, both 27.3 cents.
Its not as complex as it seems. Look at this table with simplified entries to see the essence of what the above diagram is telling you. Receivables increase by 3 plusses, inventory by 2, and PPE by 2 that means 7 in USES of funds. Payables increase by 2 plusses and retained earnings by 1 that means 3 in SOURCES of funds. 7 USES less 3 SOURCES means a shortage, EFN, of 4. Add in EFN, and the balance sheet balances, 7 and 7.
Think back to both the short-form and long-form financial forecast covered in this chapter. Each one forecasted an income statement and a balance sheet. If uses and sources in the balance sheet did not balance, external financing required provided the plus figure to force a balance. The analysis just presented in the form of a pared-down balance sheet shows you the same process, minus all of the row-by-row detail. You can take in the whole process of estimating EFN with one diagram covering half a page.
Most revealing is that for most companies operating in competitive environments, the asset side of the balance sheet is likely to grow faster than the liability and equity side. This means that external financing will always be needed as long as revenues grow.
Now that you understand what the table portrays, realize its importance for most businesses, the left side (USES of funds) of their balance sheets grow faster than their right sides (SOURCES of funds). This means that the money to support growth of the Assets Liabiliies & Equity Receivables +++ Payables ++ Inventory ++ PPE ++ Retained Earnings + Total +++++++ Total +++ EFN ++++
47 business must come from external sources. Examine the following four examples to reinforce the concept.
The first box shows current assets increasing by 30 cents per dollar of revenue increase, with no PPE increase because of excess plant capacity, 20 cents of current liabilities increase, and 5 cents of profit margin. EFN equals 5 to balance use and source.
The second box increases PPE from zero to 10 with everything else the same. The additional 10 of uses causes EFN to increase from 10 to 15.
The third box is an atypical business with a very high profit margin, 30%. It may be a semi-monopolistic company like Microsoft. EFN is negative because high profit margin causes sources of 50 to exceed uses of 30. For most businesses, high profit margins attract competitors, driving down the profit margin.
ASSETS (SOURCES) LIABILITIES (USES) Current Assets 30 Current Liabilities 20 PPE 0 Long-term debt 0 Equity 30 Change in Sources 50 EFN (Plug) -20 Change in Uses 30 Adj Chg in Sources 30 CHANGES STATED AS CENTS/$ REVENUE CHANGE ASSETS (SOURCES) LIABILITIES (USES) Current Assets 30 Current Liabilities 20 PPE 0 Long-term debt 0 Equity 5 Change in Sources 25 EFN (Plug) 5 Change in Uses 30 Adj Chg in Sources 30 LIABILITIES (USES) Current Assets 30 Current Liabilities 20 PPE 10 Long-term debt 0 Equity 5 Change in Sources 25 EFN (Plug) 15 Change in Uses 40 Adj Chg in Sources 40 CHANGES STATED AS CENTS/$ REVENUE CHANGE ASSETS (SOURCES)
48 The fourth box shows a no-growth scenario, portraying a CASH COW. No changes in either assets or liabilities because revenue does not grow, so profit margin is a source of funds with no uses.
CHANGES STATED AS CENTS/$ REVENUE CHANGE ASSETS (SOURCES) LIABILITIES (USES) Current Assets 0 Current Liabilities 0 PPE 0 Long-term debt 0 Equity 5 Change in Sources 5 EFN (Plug) -5 Change in Uses 0 Adj Chg in Sources 0
49
CHAPTER 4 FINANCIAL ARITHMETIC THE TIME VALUE OF MONEY
Knowledge of financial arithmetic is crucial, as is tying knots for surgeons. You must know it because these techniques are the conceptual underpinnings of financial analysis.
Time value of money is the workhorse concept of financial analysis. It is based on the simple fact that the 1 euro you have today is no longer 1 euro tomorrow. By tomorrow, today's 1 euro will be worth more because it earns interest. If money is worth 12% per year, that is the same as 1% per month or .03% per day. So 1 euro today is worth 1.0003 tomorrow or 1.12 one year later (using annual compounding). Accordingly, you will pay less than 1 euro right now, today, for the right to receive 1 euro tomorrow. This is the impact of compound interest. 2 Each day, the amount grows, with the original 1 euro earning interest and the interest earning interest. 3 Just ask yourself if you are indifferent about receiving 1,000 either right now or one year from now. Most people, including all of the rational ones, prefer to receive the money now rather than later. This is why one euro today is worth more than one euro tomorrow. Today's 1 euro will be worth 1.003 tomorrow; that is more than waiting until tomorrow to get the 1 euro.
Because of the time value of money, when a financial analyst compares amounts of money (cash flows), the time dimension must always be taken into account (unless all of the cash flows occur at the same moment). When evaluating cash flows at various dates in the future, the financial analyst adjusts them to their equivalent value as of one point in time, using an estimated interest rate: If the equivalent value is at the initial date, the process is called discounting, or discounting to present value. Present values are smaller than future values. If the equivalent value is at the terminal date, the process is called compounding, or growing, or compounding to future value. Future values are larger than present values. The interest rate used for the process is called either the discount rate or the growth rate. It measures the cost of money.
Basics of Time Value of Money
A lump sum is an amount of money paid or received at one date. An annuity is a series of amounts of money, periodic payments, all in the same amount, paid or received over a period of time with constant time intervals.
2 The difference between the simple interest formula i = prt that you learned in primary school is that compounding involves interest-on-interest. The simple interest formula works only when there is a single compounding period. Otherwise, it will give you an incorrect result. 3 You may imagine that inflation is the reason why today's euro is worth more than tomorrow's euro. This is incorrect. The cause is the time value of money.
50 Table 4.1
Table 4.1 shows you four 4 possible calculations, PV of lump sum, PV of annuity, FV of lump sum, and FV of annuity. The two lump sum calculations use the basic time value of money formula, (1+i) n . To get a PV, you multiply the future amount by the reciprocal of the formula. To get a FV, you multiply the present amount by the formula. The four tables at the end of the chapter, referred to in Table 4.1, are nothing more than combinations of the time value inputs, i for the interest rate, and n for the number of periods. This chapter explains how this works.
There are only five possible parameters involved. Lump sum calculations involve only four of them, because there is no periodic payment. Your aim is to identify the known values and solve for the unknown value: 1. a periodic interest rate, i 2. a number of time periods, n, starting at an initial date and ending at a terminal date 3. a Present Value, PV 4. a Future Value, FV 5. a Periodic Payment, pmt
The Growth Rate Formula is the Building Block
You start with 1 euro that earns 10% interest for one year, giving an ending balance of 1.10 euro. For the second year, you start with 1.10 euro, which earns another year's worth of interest, giving you an ending balance of 1.21 euro. And so on, for the entire eight-year period until you end up with 2.14 euro.
Table 4.2
4 Because an annuity can be thought of as a series of lump sums, one might disregard the annuity formulas and treat everything as lump sums, discounting or compounding each one separately, then summing the results.
51
Restating the Table 4.2 as an equation, it becomes
Therefore, the expression (1+i) n is the basic building block of present value and future value computations. Using the following equation, you solve for a FV by multiplying by the factor (1+i) n and you solve for a PV by dividing by the factor (1+i) n :
FV = PV x (1+i) n
The above applies to lump sums only. For annuities, the equation becomes slightly more complex because 1 euro must be added to the balance at the beginning of each period. It is never necessary to memorize the annuity equations because the table values give you the results.
Time Value of Money
Now that you recognize that cash flows occurring at different times cannot be added together without first adjusting for the time value of money, look at the examples in Table 4.3. Suppose there are three choices for receiving a 30,000 euro lump sum payment, Scenarios A, B, or C. Which one is best, or are they the same, using an interest rate of 12%? Table 4.3
There should be little doubt in your mind that Scenario B is best. Inspection of the data makes this obvious. A rational person would not select A or C over B, because the eventual value of the 30,000 euro in hand right now, at the end of the three years when all flows are complete, will be worth more than the other two. In financial analyst's language, the present value of B is greater than the present values of A and C. You can also glean the same information from looking at the future values of the three scenarios. (Either present value (at the initial date) or future value (at the terminal date) gives you the information needed;
52 showing both of them is redundant. They are both shown here to make the point.) The 30,000 euro given as totals are not relevant because they do not take the time value of money into account. But, if the three scenarios were not so easy to evaluate by inspection, what would you do? Let's look at two more sets of cash flows:
Which one is best, D or F? Each totals 30,000 euro. But, you already know that financial analysts do not sum cash flows occurring at different times without first making adjustments for the time value of money; the 30,000 euro given as totals are useless for decision making. You can find out which flow is best by selecting the one with the highest present or future value. As you can see, D is preferred over E.
Table 4.4 illustrates the by-hand calculation for Scenario D with annual cash flows and a 12% discount rate. The lump sum values are multiplied by the discount factor and summed.
Table 4.4
To summarize, the purpose of the time value of money adjustment is to allow for the proper comparison of cash flows occurring at different times. You often hear someone say, in discussing a poorly conceived analysis, that apples and oranges are being compared. The implication is that the conclusion is wrong because apples cannot be compared to oranges. In financial analysis, summing euro amounts from different time periods is an apples-to-oranges comparison; it is wrong. You cannot add (or subtract) today's euro to a euro at any other time without first taking into account the fact that tomorrow's euro will be today's euro plus compounded interest. Because today's euro is worth more than tomorrow's euro, the euro must be adjusted to a common base in time before they can be summed. Apples-to-oranges is converted to apples-to-apples by applying the present value adjustment.
The most efficient way to portray the time value of money uses a spreadsheet. Cash flows are spread over time. Table 4.5 is a generic spreadsheet. This sheet shows three categories of cash flows and their annual totals. It portrays 150 invested, shown as a negative because it is an outflow, which generates annual cash inflows of 40, 50, 60, and 70, followed by a final flow of 20, simulating an investment in a typical business project. Notice that Column F is period zero, the starting point in time for the project. Period zero shows a cash flow occurring today; period 1 shows a cash flow occurring one period later, and so on. Cash flows occur at a moment in time, which can be confusing because they are called flows. The present value of the flows is calculated in cell F24, discounting the numbers in cells F23-J23. Note that the PV of the cash flow in F23 equals (150) because the PV of todays cash flow is multiplied by (1+i) 0 , which is 1.
53 Table 4.5
You can see from Table 4.6 and 4.7 that this is the universal format for handling cash flows of all kinds, summarizing them by calculating either their present or future values. Table 4.6 shows the cash flows in a bond contract. Table 4.7 shows the cash flows from an equity investment. In both tables, the present value of the cash flows, at a discount rate of 12%, shows the value of the bond or the stock to an investor expecting the cash flows as portrayed.
Table 4.6
In Table 4.6, for a bond, the PV of the cash flows is 94. In Table 4.7, for a stock, the PV of the cash flows is 114.
Table 4.7
Tables for Compounding & Discounting
There are four tables, where the i represents the interest rates and the n the time periods. If the period is yearly, table values for i and n are on an annual basis already and require no adjustment. If the period is semi-annual, the annual i must be halved and the annual n doubled; there are twice as many semi-annual periods as annual periods, and the interest rate is half as large. If the period is quarterly, the i is divided by four and the n is multiplied by four, and so on for periods of any length.
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TABLE A: PRESENT VALUE OF LUMP SUM
PV = FV x PVIF i,n
where the table factor, PVIF i,n
is 1 (1+ i) n
This equation is used by plugging in three knowns (n, i, and FV) and solving for the unknown (PV). Note that the numerical values of all table factors are less than one. Also note that Tables A and C are reciprocals.
55
TABLE B: PRESENT VALUE OF ANNUITY
PVA = PERIODIC PAYMENT x PVIFA i,n
The table factor PVIFA i,n
The equation is used by plugging in three knowns (n, i, pmt) and solving for the unknown (PVA).
56 TABLE C: FUTURE VALUE OF LUMP SUM
FV = PV x FVIF i,n
where (1+i) n is the table factor FVIF i,n
This equation is used by plugging in three knowns (n, i, PV) and solving for the unknown (FV). Not that all table factors are greater than one. Also note that Tables A and C are reciprocals. Table C factors are also called growth factors or compound annual growth rate (CAG).
57 TABLE D: FUTURE VALUE OF ANNUITY
FVA = PERIODIC PAYMENT x FVIFA i,n
The table factor FVIFA i,n
This equation is used by plugging in three knowns (n, i, pmt) and solving for the unknown (FVA).
58 Automating the Calculations Using HandyCalc
A useful generalization is made from examining these calculations, which will help you to hone your understanding of financial arithmetic. You see that there are four possible calculations. For the lump sum calculations there are four data items; you know three of them (the givens) and solve for the fourth (the result).
For the annuity calculations, there are five data items; you know four of them (the givens) and solve for the fifth (the result). You plug in the knowns and solve for the unknown. The discounting and compounding tables previously shown have the number of periods in the first column, undefined as to the length of the period. HandyCalc.xls allows you to refine the time measure by specifying the number of periods per year; that is why you enter one more known value in timecalc.xls than in the table calculations you do by hand.
The tables in this section are in the HandyCalc tab in the Morgan-Green Template Set. It performs 9 kinds of calculations: 1. Future value of a lump sum - solving for FV 2. Present value of a lump sum - solving for PV 3. Future value of an annuity - solving for FV 4. Present value of an annuity - solving for PV 5. Amount of mortgage payment - solving for periodic payment 6. Periodic deposit needed to accumulate a given sum - solving for periodic payment 7. Growth rate for given beginning and ending values of a lump sum - solving for interest rate 8. Years needed to grow a lump sum to a given ending value - solving for number of periods 9. Years needed to grow period payments to a given ending value - solving for number of periods.
Table 4.8, reading from left to right, does calculations for future value of lump sum (Table C in the text) present value of a lump sum (Table A) future value of annuity (Table D) present value of an annuity (Table B)
The four calculations automate the same calculations you could do by hand using the Tables A-D.
Enter the givens and the computer instantly provides the result. Interest rates are always entered as decimals6% goes in as .06. Each box is for a separate type of calculation.
Select the type of computation you want, using columns B-D. Numbers are entered in blue- colored bold cells. The bottom line, RESULT, is the answer. Note that the given for lump sums is a Amount expressed as a lump sum and the given for an annuity is a periodic payment. An input for periods per year automatically annualizes the results. If the flows are annual, enter 1; if quarterly, enter 4; if monthly, enter 12. If you are not sure about the match up between n and I, review the text again. The NA appears in the first two calculations because there is no periodic payment involved in a lump sum calculation. NA
59 appears in the last two calculations because no lump sum is involved in an annuity calculation. FV of Lump Sum compounds a PV at the specified interest rate for the specified period of time PV of Lump Sum discounts a FV at a specified interest rate for the specified period of time FV of Annuity compounds a series of periodic payments into a FV accumulation at a specified interest rate for the specified period of time PV of Annuity gives the lump sum PV equivalent of a series of periodic payments at a specified interest rate for the specified period of time
Table 4.8
Table 4.9 is a variation on theme. Here the answer is the payment required to achieve a known PV or FV rather than the PV or FV. As in Table 4.8, the numbers in bold are entered into the template (you choose whether to use one or both of the two columns, B and/or C, leaving the other blank). The bottom line, RESULT, is the answer, Mortgage Payment is computed based on the periods, interest rate, and amount of the loan. Note that the amount of a loan is a present value. It can be used to figure the payment on auto loans or home mortgages. By varying the periods per year, it will figure monthly, quarterly, semi-annual, or annual payments. Deposit to Accumulate is a variation of the future value of an annuity calculation. The Amount is what you want to accumulate after a known number of periods in a retirement fund, for example. The answer is the periodic payment required to accumulate that sum.
Table 4.9
The third panel offers further variations. Here the givens list six data items, but not all of them are used for each calculation. If you go back to Panel One for a quick look, notice that
60 the givens for all four calculations are the same all the way across, and the result is either a PV or FV, depending on what type of calculation it is. If you go back to Panel Two, again the givens are the same all the way across, and the result is a periodic payment. But, in Panel Three, the result for the first calculation is a percentage interest rate (rate of return), and in the second and third it is a number of periods. Lump Sum Growth Rate, computes the rate of return when the beginning and ending euro amounts are known. This is useful when you have a known PV, FV and number of years and need to know what the growth rate is. Since the euro amounts are lump sums, the periodic payment is NA. For example, when you have 50 euro and need 60 euro in one year. A 20% rate of return is needed to grow the beginning amount to the ending amount over the specified time period. Since the euro amounts are lump sums, the periodic payment is NA. Years to Grow Lump Sum gives you the number of periods it takes to go from a known PV to a known FV with a known interest rate. Years to Grow Annuity gives youre the number of periods it takes to grow a series of periodic payments at a known interest rate into a known FV.
Table 4.10
61 CHAPTER 5 CAPITAL BUDGETING & COST OF CAPITAL
This chapter is about the GREEN blocks in the IS/BS Model the property, plant and equipment on the balance sheet, and the resulting expenses on the income statement as property, plant and equipment is operated to produce goods and services for customers. Also called cost-benefit analysis, sometimes called project analysis, project valuation or investment decision, capital budgeting is a procedure to make sure the investment in plant, property and equipment and the investment in working capital, is justified by the prospective rate of return on the project.
Overview of Capital Budgeting
Introduction
Capital budgeting, investment analysis, project valuation, project analysis and cost-benefit analysis are interchangeable synonyms. The analysis assists in deciding if proposed projects are justified when comparing the cash flows invested in them to the cash flows they generate. These are before-the-fact decisions where financial managers crunch the numbers on project proposals coming from operating managers. Projects that dont pay their own way will drain the resources of the business and destroy its value. Therefore, these decisions are crucial for operating managers who want to grow their businesses, and not grow them into the ground by investing more in a project than it is worth.
Learning Objectives: 1. Understand creation and destruction of shareholder value that explains why capital budgeting is so important to managers 2. Understand the importance of either green lighting or red lighting a project backed by a sensible analysis
62 3. Appreciate the differences between operating cash flows and capital cash flows, that operating cash flows come from the income statement (revenue minus operating expense) and capital cash flows come from the balance sheet (changes net working capital and capital expenditures for property, plant and equipment) 4. Know how to apply the step-by-step capital budgeting methodology
Creation and destruction of shareholder value why capital budgeting is so important
The combined cash flows for all the projects in the business are the basis for the businesss value. Simply stated, the value of a business is the present value of its free cash flows. If the cash flows for all projects in the business have satisfactory rates of return, which allowed each one of them to be accepted (green-lighted), then the aggregate cash flows for all the projects will provide a satisfactory overall rate of return for the whole business. With satisfactory rates of return, the value of the business is maintained or increased. Conversely, with unsatisfactory rates of return, the value of the business declines. Capital budgeting is vitally important because it offers an advance look, before the investment is made, into whether or not a proposed project is value creating (green light) or value destroying (red light). As this chapter unfolds, you will learn how to use the classic methodology of capital budgeting, perhaps the most widely used and abused tool of financial analysis.
Look at the two sets of photos to get yourself thinking about the choices a business makes about what kind of property, plant and equipment it invests its money in. The paint spraying operation in the first set of photos can be simple or high tech. Simple implies low investment in fixed assets on the balance sheet and low (not always) fixed costs on the income statement. If you have a dozen workers painting your products with a spray can, investment is low. Fixed cost is low because you can lay off the workers if sales slow down, making them a variable cost rather than a fixed cost. The robotic painter requires a high investment outlay and generates high fixed cost since you cant lay it off very easily if demand for the product drops. But, it paints much more efficiently and faster than the human worker pressing a button on a spray can.
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The second set of photos repeats the same point. The assembly room operation in the first photo has people but no machines. In the second photo, its just machines but no people. It doesnt cost much to set up the first room, under $5,000 for some second- hand tables, chairs, and shelving. The second room could cost hundreds of thousands if not millions of dollars. Which approach is best, low tech or high tech, given the same production volume? Thats the job of capital budgeting to identify the cash flows involved before the investment is made, to help you make the decide which project is best. If the analysis is run to choose between the high tech vs. low tech factor, the analysis process is called a choice between mutually exclusive opportunities; it identifies which project is better than the other. Sometimes the capital budgeting process looks at only one project; here the rate of return on the project must be high enough to pass muster.
64
The classic capital budgeting process has three steps: 1. identify the relevant incremental cash flows for the project 2. calculate a discount rate, also called weighted average cost of capital, k wacc
3. calculate the decision criteria: net present value (NPV), profitability index (PI), internal rate of return (IRR), and payback period (PP).
Step 1: Identify Relevant Incremental Cash Flows
Relevant incremental cash flows are divided in two categories.
1. First, there are two categories of capital flows, the increments in the balance sheet accounts attributable to the proposed project: a. Investment in fixed assets - plant, property and equipment (PPE) b. investment in net working capital - the net of increases in accounts receivable plus inventory minus accounts payable (NWC).
Investment in fixed assets speaks for itself because a new project may require increased investment in machines, buildings, and/or land. Less obvious but equally important is that net working capital also increases, because the increased volume of business means new revenue is generated by the new project. As revenue rises, net working capital rises along with it.
2. Second are operating flows, the increments in the income statement resulting in changes in revenue and expenses created by the new project.
The with-without principle. Think of two sets of financial statements for a company. One set includes the transactions for the new project being proposed; the other set is exactly the same except it does not include anything related to the proposed new project. The capital budgeting process captures the difference between the two sets of financial statements, the first set with the project the second set without it, i.e., the increments referred to in the paragraph above. The process deals only with incremental cash flows, cash flows that are generated by the proposed project, those cash flows that would not occur without it.
Incremental cash flows not accounting accruals, not allocations of existing costs. We are measuring the flow of actual cash money not accounting accruals, not what accountants put into accrual-based income statements and balance sheets. Think of a kids lemonade stand. She uses a cigar box for the money, starting with $25 from her grandfather. To buy supplies, she takes cash out of the box. Cash received from selling lemonade goes into the box. Pure and simple, its based on cash basis only. The same idea applies to capital budgeting analysis. Cash flows are not relevant in this methodology if they dont go into or come out of the cigar box representing the project.
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Some general rules for identifying relevant incremental cash flows are: Sunk costs are not incremental costs for the project under analysis because the money is already spent. It cant be unspent if the capital budgeting process signals a red light. (Research and development costs are one possible exception to the sunk cost rule. In the pharmaceuticals industry, where research costs are huge, adaptations to standard capital budgeting procedures are made.) Allocated fixed costs such as overhead are not incremental costs because the money is already spent. Allocations are a thorny issue that causes lots of disagreements between operating managers and financial managers, especially in the face of a rule that charges all projects a flat percentage rate for corporate overhead. Erosion of sales of an old product line caused by a new product line is a relevant incremental cost and must be netted out of the proposed projects revenue forecast. When the proposed project uses excess capacity, i.e., plant and machine capacity is available without investing in new PPE for the proposed project, the existing PPE is not an incremental cash flow. It already exists and does not have to be repurchased. Nevertheless, managers may make territorial judgments, believing that the new project is getting a free ride in their plant if a charge for existing capacity does not appear in the new projects proposal. The best way to think this through is to imagine an organization chart for the company. A plant manager may think the plant is his, but in reality it belongs to the shareholders. Think of capital budgeting decisions as being vetted at the board of directors level, or at the corporate CFO level, not at the level of plant managers or product managers. The broad viewpoint of the whole company is the relevant viewpoint, not the narrow viewpoint of one product line or profit center. Managers can confuse before-the-fact capital budgeting metrics with after-the-fact performance metrics, often because of poorly designed and communicated bonus plans. Always remember the purpose of capital budgeting methodology to make the green-light or red-light decision before an investment is made. It is not a cost accounting scheme or a management performance program. Depreciation expense is triggered by the investment outlay for property, plant and equipment. Never forget to keep this connection in mind it links the balance sheet item with the income statement item. It is a tax-deductible expense, but a non-cash charge. Therefore, it is deducted to calculate income before tax, then added back to calculate after-tax cash flow. Interest expense is not a relevant cash flow in capital budgeting because the process applies the cost of capital as the discount rate. Only revenues and operating costs are considered. Including interest expense amounts to double counting. If a deduction is made for interest expense, and then the cash flows are discounted, this is tantamount to counting the financing costs twice.
66
Generic Capital Budgeting Template
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 41 42 43 44 45 46 47 48 49 50 51 52 A B C D E F G Year 0 1 2 3 4 5 Units sold 0.0 0.0 0.0 0.0 0.0 Sales price per unit 0.0 0.0 0.0 0.0 0.0 Sales revenue 0.0 0.0 0.0 0.0 0.0 Less: variable cost of good sold 0.0 0.0 0.0 0.0 0.0 Less: fixed cost of goods sold 0.0 0.0 0.0 0.0 0.0 Less: variable GS&A expense 0.0 0.0 0.0 0.0 0.0 Less: fixed GS&A expense 0.0 0.0 0.0 0.0 0.0 Less: depreciation 1.0 1.0 1.0 1.0 1.0 Equals: total operating expense 1.0 1.0 1.0 1.0 1.0 Equals: EBIT -1.0 -1.0 -1.0 -1.0 -1.0 Income tax rate & income tax 0% 0.0 0.0 0.0 0.0 0.0 Operating cash flow: EBIT -1.0 -1.0 -1.0 -1.0 -1.0 Minus: Taxes 0.0 0.0 0.0 0.0 0.0 Plus: Depreciation 1.0 1.0 1.0 1.0 1.0 Equals: Operating cash flows 0.0 0.0 0.0 0.0 0.0 Change in Net Working Capital: Revenue 0.0 0.0 0.0 0.0 0.0 Cost of goods sold 0.0 #DIV/0! #DIV/0! #DIV/0! #DIV/0! Receivables (enter days in Column B) 0 0.0 0.0 0.0 0.0 0.0 Inventory (enter days in Column B) 0 0.0 #DIV/0! #DIV/0! #DIV/0! #DIV/0! Payables (enter days in Column B) 30 0.0 #DIV/0! #DIV/0! #DIV/0! #DIV/0! Net working capital needs 0.0 #DIV/0! #DIV/0! #DIV/0! #DIV/0! Liquidation of working capital 1.0 Investment in working capital 0.0 #DIV/0! #DIV/0! #DIV/0! #DIV/0! Free cash flow: Operating cash flow 0.0 0.0 0.0 0.0 0.0 Minus: Invesment in net working capital 0.0 #DIV/0! #DIV/0! #DIV/0! #DIV/0! Minus: Investment in PPE (CapEx) 0.0 0.0 0.0 0.0 0.0 0.0 Plus: Salvage value 0.0 Free cash flow 0.0 0.0 #DIV/0! #DIV/0! #DIV/0! #DIV/0! Cumulative free cash flow 0.0 0.0 #DIV/0! #DIV/0! #DIV/0! #DIV/0! Discount rate (K-wacc) 0% Net Present Value (NPV) #DIV/0! Profitability Index (PI) #DIV/0! Internal Rate of Return (IRR) #VALUE! Payback Period inspection of cumulative FCF - row 45 SECTIONS II AND III, IN ADDITION TO THE CHANGE IN CAPITAL SPENDING SECTION V. CALCULATE DECISION CRITERIA USING FREE CASH FLOW SECTION I. CALCULATE THE CHANGE IN EBIT, TAXES, AND DEPRECIATION (THIS BECOMES AN INPUT IN THE CALCULATION OF OPERATING CASH FLOWS IN SECTION II) enter data in blue-colored cells SECTION II. CALCULATE OPERATING CASH FLOW (THIS BECOMES AN INPUT IN THE CALCULATION OF FREE CASH FLOW IN SECTION IV) SECTION III. CALCULATE THE NET WORKING CAPITAL (THIS BECOMES AN INPUT IN THE CALCULATION OF FREE CASH FLOWS IN SECTION IV) SECTION IV. CALCULATE FREE CASH FLOW (USING INFORMATION CALCULATED IN
67 Above is a Generic Capital Budgeting Template organized to enhance your learning of the steps involved in the capital budgeting process. Find a working version in Template Set.xls. Here is a step-by-step run-through of the template:
1. Section I contains income statement entries. Enter data in the blue-colored cells. Data comes from the proposed projects income statement forecast. Make sure you are comfortable with this there is nothing unique or mysterious about where the data comes from - engineering estimates, market studies, focus groups, historical data, and sometimes, mere guestimates. Recall the financial statement forecast discussed in Chapter 3, where income statements and balance sheets were projected, for the whole business. Here, income statements and balance sheets are projected only for the project under analysis. 2. Rows 5 & 6 are the two main components of revenue, unit volume and price per unit, multiplied together to get row 7, revenue. 3. Rows 8 & 9 break cost of goods sold into variable and fixed components. If the fixed vs. variable cost breakdown is not known, use only one row. Assuming that cost of goods sold is 100% variable cost, if it really has a fixed cost component, biases the analysis. It is rare, however, to find fixed vs. variable cost breakdowns in published data, so use the numbers you have, understanding their limitations. 4. Rows 10 & 11 break selling, general and administrative expenses into variable and fixed components. If the breakdown is not known, as discussed in the point above, use only one row. 5. Row 12 shows depreciation expense. Sometimes depreciation expense is included in costs of goods sold, even though its best to identify it separately on row 12. It is based on the investment in plant, property and equipment in row 42. If depreciation as a separate item is not provided, then leave this row blank, knowing that free cash flow will be underestimated because no depreciation is added back. 6. Row 13 calculates the sum of expenses in rows 8-12. 7. Row 14 subtracts row 13 total operating expenses from row 7 revenue to calculate EBIT. 8. Row 15 uses the income tax rate in cell B15 to calculate the income tax on EBIT. Note that no interest expense is considered in this template. Only operating cash flows are considered in this analysis. Interest expense, a financial cash flow, is brought into the analysis by using the k-wacc, as explained above. 9. Section II has no input cells and summarizes the income statement rows of Section I. It calculates row 23 operating cash flows by subtracting taxes from EBIT and adding back depreciation expense, a non-cash charge subtracted in Section I to arrive at total operating expense. Depreciation expense was deducted as an expense, but unlike the other expenses where cash was paid, no cash was paid for depreciation, so it must be added back after it was subtracted out to get the taxable income number so taxes can be calculated. 10. Section III contains balance sheet entries. Rows 28 and 29 are memo entries drawn from cells in Section I - they are needed to calculate row 30 receivables, row 31 inventory, and row 32 payables. Enter the days of receivables, inventories, and payables in rows B30, B31 and B32 as they are established by the working capital policy of the business.
68 11. Row 30 receivables is calculated by multiplying the days of revenues in receivables (collection period) by revenues per day, annual revenues divided by 365 days. Receivables is based on revenues. 12. Row 31 inventory is calculated by multiplying the days of inventory by cost of goods sold per day, annual cost of goods sold divided by 365. Inventory is based on cost of goods sold, not revenues, because cost of goods sold is the proxy for production cost. 13. Row 32 payables is calculated by multiplying the days in payables (payment period) by cost of goods sold divided by 365, assuming that cost of goods sold is a proxy for purchases of production inputs from suppliers. 14. Row 33 sums the total net working capital for each year, receivables plus inventory minus payables, that is required for this project. The end-of-year net working capital dollar amounts represent the cumulative total of each annual investment in NWC. Each annual investment represents the year-by-year incremental investment in NWC. Point 16 clarifies it. This is a complex calculation, often mixed up and misstated. 15. Row 34 assumes that the total investment in net working capital can be recovered at the end of the project. Therefore, cell G34 estimates a cash inflow, which may or may not actually occur. If receivables and inventory are high quality, it is likely that the cash will be received by collecting all the receivables and selling the entire inventory at the end of the projects life. If they are low quality, perhaps only 50% or less, even 0%, might be collected. The best you can do for is to make a judgment about it. 16. Row 35 calculates the incremental investment in net working capital that must be made to support this project. C35 is the initial net working capital investment for the first year of the projects life, building the working capital from scratch. Thereafter, driven by changes in revenue, net working capital changes also. The relevant cash flow for the capital budgeting analysis is not total net working capital in row 33, but the incremental change from year-to- year in row 35.
This concept is hard to grasp until you realize what is going on. With revenue constant from year to year, net working capital does not grow. Yes, there is a steady flow of transactions in and out of receivables, inventory and payables but - they stay at the dollar same level when the amount of revenue is constant, and management policy on the number of days in receivables, inventory, and payables also stays the same. When revenue increases, NWC increases: when revenue decreases, NWC decreases (spontaneous changes). Changing the number of days also causes NWC changes, but such changes are policy changes, not spontaneous changes. Think of spontaneous changes as those not requiring action by managers they happen automatically. A change in the number of days is a policy change, instigated by a manager, not automatic.
Because capital budgeting analysis must capture the incremental cash flows each year, the relevant NWC cash flows are the year-to-year differences between the cumulative year-end NWC balances on row 14.
Think of each working capital account as a faucet. Opening the receivables and/or inventory faucets to increase the flow is tantamount to offering a longer collection period - more days, or holding a larger inventory - more
69 days. For payables, opening the faucet to increase the flow means a longer payment period - more days, taking on more credit from suppliers. The analogy of faucets explains that working capital items are easily adjustable because cash flows go in and out of these accounts every day; the settings on faucets can be adjusted easily. If too much or too little investment in NWC is made, the remedy is easy to implement. Conversely, for plant, property and equipment, fixed assets, if too much is invested, in brick and mortar and machines, adjustments are slow and costly, because they are one-time transactions as opposed to the day-in day-out transactions in working capital accounts.
A panel from the Generic Capital Budgeting Template illustrates the very important points of this discussion about NWC. The spreadsheet rows in the first panel below show constant revenue in row 28, the same for cost of goods sold in row 29 - the business is operating in a steady state. With the days of receivables, inventory, and payables in B30.32, each working capital item is calculated in rows 30, 31, and 32, then summed (minus for payables) in row 33. Each number in row 33 shows the cumulative NWC at the end of each of the five years forecasted. They are all the same, 83.7, because revenue was constant, cost of goods sold was constant, and the days were constant. Therefore, investment in NWC occurs only once in this example, in the first year, C35. For the other years, NWC does not increase or decrease, so each subsequent years investment in NWC is zero no change in revenue or days, no change in NWC.
Now look at a spreadsheet where revenue increases each year, in the second panel. Here, revenue and cost of goods sold increases, causing each component of NWC to increase along with it. Instead of 83.7 in all cells of row 33 in the top panel, this panel shows increasing NWC totals for each year. The increments in row 35 are the differences year-by-year. These differences, the increments, are what you want to capture for the capital budgeting analysis.
28 29 30 31 32 33 34 35 A B C D E F G Revenue 1000.0 1000.0 1000.0 1000.0 1000.0 Cost of goods sold 22.0 22.0 22.0 22.0 22.0 Receivables (enter days in Column B) 30 82.2 82.2 82.2 82.2 82.2 Inventory (enter days in Column B) 50 3.0 3.0 3.0 3.0 3.0 Payables (enter days in Column B) 25 1.5 1.5 1.5 1.5 1.5 Net working capital needs 83.7 83.7 83.7 83.7 83.7 Liquidation of working capital 0.0 Investment in working capital 83.7 0.0 0.0 0.0 0.0
70 17. Section IV completes Step 1 of the capital budgeting template by compiling results from Sections II and III and entering the investment in fixed assets (property, plant and equipment PPE also called Capital Expenditures) in cell B42. These numbers combine to calculate FREE CASH FLOW (always make sure that the + or signs are as you intend mistakes here are commonly found errors in capital budgeting. These FREE CASH FLOW numbers, for each year of the forecast, is the objective of Step 1, i.e., determining the relevant incremental cash flows. Row 40 is drawn from row 23, row 41 drawn from row 35 is subtracted, row 42 capital expenditure is deducted, and G43 salvage value if any is added. The result is B44. (FREE CASH FLOW is called Net After Tax Cash Flow (NATCF) by some financial analysts.)
Step 2: Calculate the Discount Rate Weighted Average Cost of Capital (k wacc )
A discount rate is needed before you can perform the present value calculations in Section IV of the Generic Capital Budgeting Template. This topic explains cost of capital the discount rate used in capital budgeting calculations. See how the IS/BS Diagram depicts cost of debt and cost of equity, the two components of cost of capital, also known as k wacc . Also, see how the Flow Diagram in the top-left corner depicts the steps in financial analysis. The k wacc calculation step comes before capital budgeting, because the discount rate is an input to the capital budgeting analysis.
INCOME STATEMENT BALANCE SHEET WORKING CAPITAL Revenue ASSETS LIABILITIES AND EQUITY changes spontaneously with revenue Cost of sales Current assets Current liabilities ?what levels of ca, cl, s-t loans? Gross profit Cash Trade payables CAPITAL BUDGETING Other operating income Investments Other accruals ?which projects to accept? Other operating expenses Trade receivables Tax liabilities FINANCING Total cost and expenses Inventories Short-term loans, leases ?how much debt capacity? Operating profit (EBIT) Non-current assets Non-current liabilities Interest, finance costs Property, plant & equipment Loans, debt, leases due after 1 year Profit before tax Investment property Retirement benefit obligation COST OF DEBT Income tax Goodwill Deferred tax liabilities Net profit after tax Total non-current liabilities Dividends K-WACC Reinvested in the business Stockholder's equity (Net worth) Preferred stock OPERATING LEVERAGE Common stock COST OF EQUITY Additional paid-in-capital FINANCIAL LEVERAGE Retained earnings VALUATION CASH FLOW Total assets Total liabilities & equity COST OF CAPITAL 28 29 30 31 32 33 34 35 A B C D E F G Revenue 1000.0 1100.0 1200.0 1300.0 1400.0 Cost of goods sold 22.0 24.2 26.4 28.6 30.8 Receivables (enter days in Column B) 30 82.2 90.4 98.6 106.8 115.1 Inventory (enter days in Column B) 50 3.0 3.3 3.6 3.9 4.2 Payables (enter days in Column B) 25 1.5 1.7 1.8 2.0 2.1 Net working capital needs 83.7 92.1 100.4 108.8 117.2 Liquidation of working capital 0.0 Investment in working capital 83.7 8.4 8.4 8.4 8.4
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Learning Objectives: 1. Understand why cost of capital (also known as k wacc , the investors required rate of return) is the discount rate used in capital budgeting and valuation calculations 2. Know that the cost of capital percentage is directly related to the riskiness inherent in the cash flows under analysis - the more the cash flows are likely to vary, the higher the cost of capital 3. Know how to calculate cost of debt, k d
4. Know how to calculate cost of equity, k e
5. Know how to combine k d and k e as a weighted average to get k wacc
6. Appreciate the danger of excessive risk adjustment 7. Know how to use the cost of capital template
Cost of debt is (somewhat) concrete
The cost of debt concept may not be quite as concrete and palpable as the sidewalk in the picture above, but it is close. Cost of capital is not be animal, vegetable or mineral, but its two components are observable: 1. Interest rate on borrowed money. 2. Income tax rate.
These rates are relatively unambiguous because a business knows the rate of interest it pays on borrowed money and it knows its income tax rate.
The bond certificate below has the rate of interest (the coupon rate) printed on it. A loan agreement includes an interest rate as part of the contract.
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This tax rate schedule shows the rate charged to corporations in the United States.
Therefore, calculating cost of debt is fairly straightforward:
COST OF DEBT = INTEREST RATE * (1 - TAX RATE), using the notation k d
Cost of equity not so tangible
Calculating cost of equity is sometimes a challenge. It is very hard to get exactly right, because its components are ambiguous compared to the components for cost of debt. They are not as close to animal, vegetable or mineral as cost of debt is.
73 Think of cost of equity as a ghost lurking in a cloud. Cost of debt? I can see and feel it a concrete sidewalk. Cost of equity? I cant see it. I have to conjure it up. Its a ghost in a cloud.
CAPM: COST OF EQUITY = RISK-FREE-RATE + (BETA x RISK PREMIUM)
Tap a finance major on the shoulder at any time, any where, day or night, ask for the Capital Asset Pricing Model (CAPM) equation, as above, and you should get a quick, correct response. It is vita and universal. Even if you are not a finance major, learn it. You will appreciate the elegance of its logic.
The components of cost of equity are Risk-free rate Beta Equity risk premium (ERP) 5
5 According to Professor Pablo Fernandez, the average Equity Risk Premium (ERP) used by analysts in 2009 in the USA (5.1%) was similar to the one used by their colleagues in Europe (5.0%). But the average ERP used by companies in the USA (5.3%) was smaller than the one used by companies in Europe (5.7%), and UK (5.6%).The dispersion of the analysts ERP used was high, but lower than the one of the professors: the average range of ERP used by analysts (companies) for the same country was 5.7% (4.1%) and the average standard deviation was 1.7% (1.2%). These statistics were 7.4% and 2.4% for the professors. He reviewed 100 finance and valuation textbooks published between 1979 and 2008 (Brealey, Myers, Copeland, Damodaran, Merton, Ross, Bruner, Bodie, Penman, Weston, Arzac...) and found that their recommendations regarding the equity premium range from 3% to 10%, and that several books use different equity premia in different pages. Some confusion arises from not distinguishing among the four concepts that the word equity premium designates: Historical equity premium, Expected equity premium, Required equity premium and Implied equity premium. Finance professors should clarify the different concepts of equity premium and convey a clearer message about their sensible magnitudes.
74 Which risk-free rate to choose, 90-day, 180-day, 1-year, 5-year, 10-year, 20-year, 30- year? Match the maturity of the risk-free security to the time horizon of the cash flows you are evaluating.
The role for Beta is to tailor the cost of equity (a rate of return required by the stockholder) to the risk of a particular company. A popular finance writer says insert a fudge factor known as the companys equity beta He is correct in calling the beta a fudge factor, because it is so inexact. It is a handicapper to estimate the risk profile of the company whose cost of equity is being estimated.
Which equity risk premium to choose? Depending on the time period and data series you choose, or the financial analyst you talk to, it ranges from 3% to 10%. Risk premia are computed by taking the difference between the annual rate of return on a stock market index such as the S&P 500 and the risk-free rate (the yield on a government security). To the extent that the choice of risk premium for this calculation is inexact or arbitrary, the resulting cost of equity is also inexact and arbitrary. Cost of equity is very hard to observe concretely and is full of ambiguity.
Nevertheless, we calculate it as:
COST OF EQUITY = RISK-FREE RATE + [BETA x EQUITY RISK PREMIUM],
using the notation k e , the CAPM equation, one of the most famous in finance, for which William Sharpe earned his Nobel Prize.
The hardest thing to absorb about cost of equity is this: it is truly a cost. You might think that if a business has no obligation to pay dividends, equity has no cost. If it does pay dividends, it can cut or eliminate them at any time. Therefore, since there is no need to pay anything to shareholders, you assume there is no cost connected to equity. If you think that, you are wrong about a foundation concept in finance. A business must satisfy its shareholders by providing a rate of return on their investment. Please, work hard on seeing cost of equity as the required rate of return that shareholders demand. Forgive me for repeating it so many times, but many smart people get it backwards, believing that equity costs a company less because it does not have to pay interest on stock like it does on bonds.
In the chart below on the left, you see the calculation that generates Beta, the slope of the regression line in an ordinary least squares (OLS) regression.
The beta coefficient is the slope of a least squares regression line. The independent variable is the rate of return on a market index of equity shares. The dependent variable is the rate of return on the companys equity shares. Matched pairs of data are generally used covering 60 monthly periods. RETURN ON COMPANY SHARE return Security Market Line (SML) 13.0% slope of the line is Beta coefficient undervalued 10% RETURN ON MARKET INDEX market portfolio Beta = 1 overvalued market portfolio intercept = 0 5.0% risk-free rate OLS Regression - Characteristic Line 1.0 risk (Beta) Expected Return = Risk-Free Rate + (Beta x Risk Premium)
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Therefore, the beta is an index measuring the volatility of the companys shares relative to the volatility of the equity market index, providing a measure of risk specific to the company under analysis. A Beta of 1.11 means that the rate of return on a stock is 1.11 times the rate of return on the market index, for the 60-month period over which data is drawn. Stated another way, if the market return is x%, the rate of return for a stock is expected to be 1.11 times x%, because of the risk that is specific to this company.
Do not to confuse the OLS diagram on the left, displaying the characteristic line, with the diagram on the right displaying the security market line. The market line shows the relationship between risk and return, always plotting risk on the horizontal axis, with the normal line moving upward to the right because more risk requires more return. Riskier bonds have higher YTMs than less risky ones. Stocks have higher rates of return than bonds. The intercept of the market line with the vertical axis shows the risk-free rate. The characteristic line is the result of an OLS regression analysis. The slope of the characteristic line is the Beta of the stock under analysis. The Beta measures the volatility of the stocks return compared with the volatility of the markets return.
Putting it all together calculating weighted average cost of capital, k wacc
A. Basic K- wacc , Calculation of Weighted Average Cost of Capital
The template below calculates K- wacc using this equation (notice the formulas and equations in Columns C & D they are explained in this section):
K-WACC = [COST OF DEBT x % OF DEBT] + [COST OF EQUITY x % OF EQUITY]
The 10.90% weighed average cost of capital figure computed in cell B17 of table above has three components: The cost of debt financing The cost of equity financing 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 A B C D BASIC: Formula Equation COST OF DEBT: Coupon Rate 7.00% given Marginal Tax Rate 15.6% given Cost of Debt 5.91% b5*(1-b6) k-d = I x (1- t) weight of debt 50% See Table 5.4 d d+e COST OF EQUITY: Risk-Free Rate 5.50% given Risk Premium 8.00% given R-m - R-f Beta 1.30 given Cost of Equity 15.90% b11+(b13*b12) k-e = R-f + [ x (R-m - R-f)] weight of equity 50% 1-b8 e d+e Weighted-Average Cost of Capital 10.90% (b8*b7)+(b15*b14) (k-d x wt-d)+(k-e x wt-e)
76 The proportion of debt and the proportion of equity used in financing the business, totaling 100%
1. Rows 4-8 compute the cost of debt. It is a measure of the interest rate on loans and debt on an after-tax basis, since financing cost is tax deductible. 2. B5 is the coupon rate on debt. 3. B6 is the marginal tax rate. 4. B7 calculates the cost of debt at 5.91%, B5 x (1-B6). The term (1-B6) represents 100% minus the tax rate. Each dollar of interest does not cost the company one full dollar because interest expense is tax deductible. With a tax rate of 15.6%, 15.6 cents of each interest dollar is subsidized by the tax authority. The after-tax cost is therefore 100% minus 15.6%, or 84.4%. (1-B6) = 84.4%. 5. The proportion debt financing to total financing is in B8, 50%. The rounded 50% proportion of debt consists of non-current leases (0.9) and loans (413.1), and that the 50% proportion of equity consists of share capital (120), capital reserves (32.9), and accumulated profits (259.7). Therefore, the debt proportion is 0.9+413.1 divided by 0.9+413.1+120+32.9+259.7, or 414.0/826.6, which is rounded to 50%. If the debt proportion is 50%, the equity proportion in B15 is 1 minus debt proportion (1-.50), which is 50%. 6. Rows 10 through 14 compute the cost of equity. It is an estimate of the rate of return required by equity investors in the company. A proxy for this is given by an equation universally known in modern finance, the Capital Asset Pricing Model (CAPM), a model holding that rate of return must always be proportional to risk. 7. Start with the risk-free rate in cell B11 (the rate of return on a default-proof government security). 8. Add an equity risk premium to reflect the additional risk assumed by an equity investor holding a diversified portfolio such as the EAFE Index or the S&P 500 Index. Equity risk premia range from 4% to 8% historically, with 8% arbitrarily chosen for this analysis as in cell B12, the high end of the historical range. But, these measures refer to the capital market in general, not the specific risk of a company. 9. A parameter known as Beta brings the business and financial risk into the model, set at 1.30 shown in cell B13. 10. B14 calculates the cost of equity using the CAPM equation in the box below. 11. B15 shows the weight of equity, the equity proportion of financing to total financing, discussed in point 5 above. The equity weight is 100% minus the debt weight. 12. B17 calculates the weighted average of the two components of cost of capital, cost of debt and cost of equity combined, 10.90%, the result we are seeking. It is the required rate of return that the capital market expects the company to generate on its projects, the discount rate we use in the Generic Capital Budgeting Model.
77 B. Advanced K- wacc , Calculation of Weighted-Average-Cost-of-Capital Using Re- Levered Beta The previous calculation, basic K- wacc , used the published Beta coefficient as a given. The advanced approach explained here adds one element to the calculation: it adjusts the Beta to match the target capital structure of the business for which you are calculating k- wacc . A company with a higher debt ratio will have a higher K- wacc , reflecting its higher risk. The logic behind this process is straight-forward: Weighted-average-cost-of-capital is used as a discount rate. Discount rates adjust a series of cash flows for time value of money and risk. Risk is divided into two categories; business risk and financial risk. The higher the debt ratio, the greater the financial risk, the higher the beta. More business risk means more variability in operating profit, which means a higher beta. Therefore, it makes sense to adjust the Beta coefficient to match it with the level of financial risk incurred by the company. An unlevered Beta, -ul, measures only business risk, based on a capital structure with no debt in it, i.e., a debt ratio of zero. If a company has debt, it has financial risk in addition to business risk. Since Beta must reflect both business risk and financial risk, the unlevered Beta must be adjusted, making it a levered beta, -l.
Because published betas include both business risk and financial risk, the advanced calculation of K- wacc has two steps: The published Beta must be unlevered, to take out the impact of financial risk, as if the company had a debt ratio of zero. This calculation uses the companys existing debt ratio, in the equation -ul = -l (1 + D/E) The resulting Beta must then be relevered using the companys target debt ratio, in the equation -l = -ul x (1 + D/E)
This calculation is used for two purposes: to estimate K- wacc for a company when the debt ratio is expected to change from its present level to estimate K- wacc for a company that does not have a published Beta because its shares are not publicly traded. Betas for peer companies are used as proxies. The debt ratios of the peer companies may not be the same as the debt ratio of the company under analysis, so their Betas are first unlevered using their debt ratios, and the resulting unlevered Betas are then relevered using the target companys debt ratio.
The table below shows the advanced calculation: 1. Row 21 lists the existing debt ratio as debt to value. 2. Row 22 converts row 21 to debt to equity, as required by the equation. 3. Row 23 lists the published Beta 4. Row 24 unlevers the published Beta. 5. Row 26 lists the target debt to value ratio 6. Row 27 converts row 26 to debt to equity, as required by the equation 7. Row 28 relevers the Beta
The rest of the calculation is the same as for the basic calculation of K- wacc , except the
78 relevered Beta is used on row 39 instead of the published Beta.
Summary
Cost of debt, k d , is (somewhat) tangible o Cost of Debt = Interest Rate x (1 - Tax Rate) Cost of equity, k e , is a ghost lurking in a cloud o Cost of Equity = Owners RRR = Risk-Free Rate + [Beta x Equity Risk Premium] Weighted average cost of capital, k wacc
o k wacc = [Cost of Debt x % of Debt] + [Cost of Equity x % of Equity] Beta, the slope of the OLS characteristic line, measures the relative volatility of the stock compared to the volatility of the market. 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 41 42 43 A B C D ADVANCED: Market Value Leverage Ratio (D/V) 10.00% given Market Value Leverage Ratio (D/E) 11.11% b21/(1-b21) LEVERAGED (EQUITY BETA) 1.10 given UNLEVERAGED (ASSET BETA) 0.99 b23/(1+b22) -ul = -l (1 + D/E)
TARGET Debt/Value Ratio 40% given TARGET Debt/Equity Ratio 67% b26/(1-b26) RE-LEVERED EQUITY BETA 1.65 b24*(1+b27) -l = -ul x (1 + D/E) COST OF DEBT: Coupon Rate 12.00% given Marginal Tax Rate 18% given Cost of Debt 9.84% b31*(1-b33) k-d = I x (1- t) weight of debt 40% b26 d d+e COST OF EQUITY: Risk-Free Rate 10.00% given Risk Premium 8.00% given Beta 1.65 b28 Cost of Equity 23.20% b37+(B38*b39) k-e = R-f + [ x (R-m - R-f)] weight of equity 60% 1-b34 e d+e Weighted-Average Cost of Capital 17.86% (b3*b34)+(b40*b41) (k-d x wt-d)+(k-e x wt-e)
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Step 3: Calculate Decision Criteria: Net Present Value, Profitability Index, Internal Rate of Return, Payback Period
Financial analysts use four 6 decision criteria to measure the relative desirability of proposed investment projects. 1. Net Present Value (NPV), which applies time value of money 2. Profitability Index (PI), also called Benefit-Cost Ratio (BCR), transforms the dollar measure of NPV to a ratio measure to facilitate ranking several projects from best to worst. 3. Internal Rate of Return (IRR), which applies time value of money 4. Payback Period (PP), is considered conceptually inaccurate because it does not consider time value of money, even though it is popular among managers.
Each of the four decision criteria is calculated in Section V of the Generic Capital Budgeting Template, rows 49-52. Cell B48 displays the discount rate of 10%, a given. B49.B52 are calculated.
Net Present Value (NPV)
Net present value measures, in absolute (not relative) money terms, the difference between the present value of cash inflows and the investment outlay. k wacc is used as the discount rate. Algebraically,
where FCF 1 , FCF 2 through FCF n are the periodic free cash flows, FCF 0 is the investment outlay at period zero, and k the discount rate k wacc .
The minimum acceptance criterion would be NPV=0, because a zero NPV means that the project rate of return equals the discount rate, the discount rate (weighted average cost of capital) used in the analysis, the minimum acceptable rate of return.
Important Warning When Calculating NPV in Excel. Excels =NPV financial function is a misnomer. If you use it carelessly, you will get the wrong NPV that could lead to the wrong decision. =NPV calculates the present value of the cash flows in the cell range cited.
6 A fifth metric is sometimes seen, even though it violates Time Value of Money rules and is considered archaic. It is Return on Capital Employed (ROCE), using average profit in the numerator and assets employed in the denominator, i.e., a return on assets ratio.
0 3 3 2 2 1 1 ) 1 ( ) 1 ( ) 1 ( FCF k FCF k FCF k FCF NPV ! + + + + + = 47 48 49 50 51 52 A B C D E F G Discount rate (K-wacc) 10% Net Present Value (NPV) 2,658 Profitability Index (PI) 2.3 Internal Rate of Return (IRR) 54% Payback Period inspection =if(c45<1,0,(c4+(D57+(=range(c45.d45)) SECTION V. CALCULATE DECISION CRITERIA USING FREE CASH FLOW
80 The number in the first cell is treated as one period hence, and so on. Therefore, enter the function this way:
=NPV(discount rate, cell range periods one thorough n)
then, enter the initial cash flow for the capital expenditure at period zero, so cell B49 looks like this:
=NPV(discount rate, cell range periods one thorough n) + (outlay at time period zero)
Be mindful of the sign on the cash flow in B44. It is a cash outlay and must be treated as a negative number.
Years ago one user of electronic spreadsheets entered the entire cell range, period zero through n, instead of the approach explained above. His NPV results were wrong, bad decisions were made, he lost his job, he sued the software company, and the judge threw the case out of court finding that the user of the software holds the responsibility for knowing how it works, not the software company.
Profitability Index (PI), also called Benefit Cost Ratio (BCR)
A variation on NPV is the Profitability Index, transforming the NPV to relative (not absolute) terms, stated as a ratio:
PV of Free Cash Inflows PV of Investment Outlay
A Profitability Index of 1.0 times is the minimum acceptance criterion, where the numerator and denominator are the same number. If NPV = 0, then PI = 1.0. A PI above 1.0 is favorable; a PI below 1.0 is unfavorable.
Internal Rate of Return (IRR)
Internal rate of return is stated as a percentage rate of return (NPV is stated in money terms and PI is stated as a ratio). The IRR is the discount rate that makes the present value of cash inflows equal to the investment outlay, giving a Net Present Value of zero. Where NPV is calculated with a formula, IRR is an identity and cannot be calculated. It is the result of a trial-and-error calculation. In Excel, the computer starts with a guessed-at discount rate, discounts the cash flows in periods 1 through n to get their present value, then compares that present value to the period zero investment outlay.
Visualize the IRR process with the formula below for NPV, the same one discussed above. Instead of entering the FCFs and k to calculate NPV, Excel enters a different k, one at a time, until it gets NPV=0. The k where NPV=0 is the IRR.
81 The Excel panel below illustrates an Excel calculation of IRR. Inputs go in row 35. I35 is a $100 deposit in a bank account at year 0 (I34). It MUST have a negative sign on it or the calculation will not work. The negative sign indicates that it is a cash outflow. The inflows are in J35.N35, representing $10 in interest received at the end of years 1-4, and the final $110 cash flow at the end of year 5 when the account is closed (final interest payment plus original deposit made at year zero). Excels built in function for calculating IRR is entered in I33: =IRR(I35.N35). Excel goes to work and produces the result in I33, IRR =10%. J33 is a label.
The illustration above provides another useful way to think of IRR. Its analogous to the rate of return on a bank account where you can deposit $100, then withdraw $10 a year for 5 years, then get your original $100 back.
WARNING: Florida Tile Buyout, which IRR is correct, 2900% or 211% ?
A journalist got himself in trouble by reporting the rate of return on the leveraged buyout of Florida Tile as 2900% (B3). He forgot to enter zeros in cells C3 & D3, so Excel did not know how to execute the calculation. Zeros in cells C7 and D7 give the correct rate of return, 211%, B8. Theres a big difference between 2900% and 211% annual rate of return. Be careful when you use Excel to compute IRR. Missing zeros in C2 and D2 cause Excel to consider those periods as non-existent, so it calculated on a 1-year basis instead of 3-years.
Payback Period (PP)
The payback period measures, in years, how long it takes to get your money back after making an investment. By cumulating the free cash flows year-by-years, as shown below, you can easily see, by inspection, how many years it takes to recover the investment of $2,000 at year zero. The cumulative free cash flows shift from negative to positive during year two, from -835 in C45 to 414 on D45. Therefore, the PP is about 2 years.
Rather than saying, inexactly, that payback takes about two years, perform a linear interpolation to find out exactly when during year 2 the cumulative free cash flow goes from minus to plus (assuming that the cash flows occur smoothly throughout the year, which is unlikely). From -835 to 415 is a change of 1,249. From -835 to 0 is a change of 835. So, 835 divided by 1,249 gives you the zero-point during year 2, 67%. Then you can say that the PP is about 1.7 years. 1 2 3 4 5 6 7 8 A B C D E 2003 2004 2005 2006 -750,000 22,500,000 IRR 2900% 2003 2004 2005 2006 -750,000 0 0 22,500,000 IRR 211% 33 34 35 I J K L M N 10% IRR 0 1 2 3 4 5 -100 10 10 10 10 110
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Variations on the Discount Rate calculated by the Cost of Capital Template
You can use the weighted average cost of capital, K- wacc , as calculated with the Cost of Capital Template, in cell B48 of the Generic Capital Budgeting Template. However, other choices can be made. Two are discussed here:
First is the issue of a corporation-wide discount rate versus tailored discount rates used for divisions of a corporation that have different lines of business, as in a conglomerate corporation. To the extent that analysts can agree about this, tailored divisional discount rates are thought to be superior to a single corporate rate. The discount rate should embrace the risk dimensions for the specific type of business that is under analysis, recognizing that these metrics vary widely between industries. A standard practice is to conjure up tailored discount rates for each division of a multi-industry corporation, using peer companies within each industry.
Second is the issue of different discount rates for different categories of projects within the same corporation, even within a single line of business. This means the use of risk- adjusted discount rates. When dozens or hundreds of project proposals are under review, not all of the projects have the same risk levels, meaning that the forecasted cash flows for some are much more certain than others, depending on the nature of the project. Typically, an array of discount rates is used, suggested by the table below.
The first category, safety or environmental projects, have a low discount rate barrier, causing NPV to be higher and giving the project an easier shot at getting a green light. Some of these projects might be considered necessary, without regard to NPV being above or below zero, such as environmental or safety projects.
The second category, engineering efficiency projects, have cash flows which are reasonably certain based on engineering estimates and prior experience with the technology. Therefore, with little expected variation from the forecasted cash flows, they can be viewed as low risk and therefore can be assigned a relatively low discount rate. Examples of such projects are improved electric motors and labor saving processes.
The third and fourth categories involve either projects that the company is already familiar with because they extend existing products or services, or new ones that the company is not already familiar with. The more familiar the company is with making and selling the product or service, the more predictable are the cash flows, and the lower the risk. To be sure, any product or service proposal is likely to have more risk than an engineering project, and the discount rate becomes risk adjusted accordingly. 44 45 A B C D E F G Free cash flow -2,000 1,165 1,249 1,249 1,249 1,249 Cumulative free cash flow -2,000 -835 414 1,663 2,912 4,161
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The spreadsheet below illustrates variations in cost of capital by industry, for several industries at the top of alphabetical order. The entire data base can be found at: http://pages.stern.nyu.edu/~adamodar/ by scrolling to Costs of Capital by Industry Sector. Recall the discussion above about beta; the data base shows you that it also varies by industry.
Discounting cash flows to their present value, using a risk-adjusted discount rate, can introduce unintended bias into the analysis. Future cash flows are discounted more heavily, implying that they are more risky. In fact, as a project matures, its cash flows may be less risky if it survives its startup years.
Critique of NPV and IRR
The NPV method requires the financial analyst to input a discount rate, which may be difficult to determine accurately. The NPV is stated in absolute money terms, which may be difficult to interpret. Because of these two characteristics of NPV, many managers prefer IRR as a decision criterion because it does not require a discount rate as an input and it is stated as an easy-to-understand percentage. But the IRR method has a problem. The compounding process inherent in the IRR calculation assumes that cash inflows can be reinvested in the business at the same rate as the IRR. When IRRs are high, this reinvestment rate assumption is often violated, rendering the IRR less accurate than NPV as a decision criterion. Therefore, theorists consider NPV to be the superior decision criterion for the capital budgeting process. Transforming it into PI turns the hard-to-interpret absolute dollar amount into an easier-to-understand relative number a ratio.
A Worked Out Example: Red or Green Light for a Proposed New Product?
Now that you understand what the capital budgeting process is about, consider this example. Universal wants to build a new plant and begin producing and selling a new product that did well in focus groups and test markets (whose costs are sunk costs and not relevant costs in the capital budgeting analysis). It uses the Generic Capital Budgeting Template to see whether or not the decision criteria lead to an accept or reject decision for the new product.
See the filled-in template below:
These are the inputs always remember that they are forecasts: 35% tax rate entered in B15 days of receivables, inventory, and payables of 45,30, and 30, respectively, entered in B30.B32 $300,000 for plant and equipment (all data are entered in the template omitting (000) entered in B42 the other cells in row 42 are left blank because no further capital expenditure is expected beyond the initial year 10.9% for cost of capital entered in B48, taken from Cost of Capital Template on page 74 row 5 gets year by year estimates of number of units of product sold row 6 gets year by year estimates of the selling price of one unit of product rows 8 & 9 get variable cost estimates
84 rows 10 & 11 get fixed cost estimates (when no fixed vs. variable cost estimates are available, use judgment) row 12 gets depreciation expense, based on 300 for plant and equipment in B42 and 10-year useful life Those are the only entries required. The formulas in the Excel spreadsheet do their work and generate the decision criteria in Section V. NPV, PI, IRR all indicate an accept decision, a green light for the proposed project. (The payback period is about 3.5 years.)
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Summary
The course logo below repeats the emphasis on cash: Cash is King! Throughout this chapter, you identified the relevant cash flows, not accounting accruals (remember the cigar box analogy). At this point, you should be able to easily define free cash flow as 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 41 42 43 44 45 46 47 48 49 50 51 52 A B C D E F G Year 0 1 2 3 4 5 Units sold 20.0 25.0 30.0 35.0 40.0 Sales price per unit 5.0 5.0 5.0 4.5 4.5 Sales revenue 100.0 125.0 150.0 157.5 180.0 Less: variable cost of good sold 1.0 1.0 1.0 1.0 1.0 Less: fixed cost of goods sold 2.0 2.0 2.0 2.0 2.0 Less: variable GS&A expense 0.5 0.5 0.5 1.0 1.0 Less: fixed GS&A expense 1.0 1.0 1.0 1.0 1.0 Less: depreciation 30.0 30.0 30.0 30.0 30.0 Equals: total operating expense 34.5 34.5 34.5 35.0 35.0 Equals: EBIT 65.5 90.5 115.5 122.5 145.0 Income tax rate & income tax 35% 22.9 31.7 40.4 42.9 50.8 Operating cash flow: EBIT 65.5 90.5 115.5 122.5 145.0 Minus: Taxes 22.9 31.7 40.4 42.9 50.8 Plus: Depreciation 30.0 30.0 30.0 30.0 30.0 Equals: Operating cash flows 72.6 88.8 105.1 109.6 124.3 Change in Net Working Capital: Revenue 100.0 125.0 150.0 157.5 180.0 Cost of goods sold 3.0 3.8 4.5 4.7 5.4 Receivables (enter days in Column B) 45 12.3 15.4 18.5 19.4 22.2 Inventory (enter days in Column B) 30 0.2 0.3 0.4 0.4 0.4 Payables (enter days in Column B) 30 0.2 0.3 0.4 0.4 0.4 Net working capital needs 12.3 15.4 18.5 19.4 22.2 Liquidation of working capital 1.0 Investment in working capital 12.3 3.1 3.1 0.9 1.8 Free cash flow: Operating cash flow 72.6 88.8 105.1 109.6 124.3 Minus: Invesment in net working capital 12.3 3.1 3.1 0.9 1.8 Minus: Investment in PPE (CapEx) 300.0 0.0 0.0 0.0 0.0 0.0 Plus: Salvage value 0.0 Free cash flow -300.0 60.2 85.7 102.0 108.7 122.5 Cumulative free cash flow -300.0 -239.8 -154.0 -52.0 56.7 179.2 Discount rate (K-wacc) 10.9% Net Present Value (NPV) 43.7 Profitability Index (PI) 1.1 Internal Rate of Return (IRR) 16% Payback Period inspection of cumulative FCF - row 45 SECTIONS II AND III, IN ADDITION TO THE CHANGE IN CAPITAL SPENDING SECTION V. CALCULATE DECISION CRITERIA USING FREE CASH FLOW SECTION I. CALCULATE THE CHANGE IN EBIT, TAXES, AND DEPRECIATION (THIS BECOMES AN INPUT IN THE CALCULATION OF OPERATING CASH FLOWS IN SECTION II) enter data in blue-colored cells SECTION II. CALCULATE OPERATING CASH FLOW (THIS BECOMES AN INPUT IN THE CALCULATION OF FREE CASH FLOW IN SECTION IV) SECTION III. CALCULATE THE NET WORKING CAPITAL (THIS BECOMES AN INPUT IN THE CALCULATION OF FREE CASH FLOWS IN SECTION IV) SECTION IV. CALCULATE FREE CASH FLOW (USING INFORMATION CALCULATED IN
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EBIT AFTER TAX PLUS DEPRECIATION EXPENSE MINUS INCREASE IN NET WORKING CAPITAL MINUS CAPITAL EXPENDITURE,
Free cash flow is calculated on row 44 of the Generic Capital Budgeting Template. Commit the definition to memory. Look at the IS/BS Model at the beginning of this chapter to refresh your memory about where each of these numbers comes from. Strengths and weaknesses of capital budgeting decision criteria are listed below: + means strength - means weakness NPV + shows value created by project + theoretically accurate uses time value of money - cant use corporate k wacc but divisional hurdle rates - absolute dollar value, not a relative, hard to rank - mathematics of discounting introduces distortion - scale - duration Profitability Index (or Benefit-Cost Ratio) + puts NPV in relative terms IRR - reinvestment rate assumption + intuitive appeal to managers + stated as percentage Payback Period - liquidity of project - no time value of money - ignores cash flows after payback + can discount cash flows before calculating payback period + cumulative cash flows easily understood
Also, know that a business can deploy money in only four ways: 1. Invest in working capital and PPE to expand via organic growth 2. Invest in other companies, growing via merger and acquisition 3. Payment of a dividend to its shareholders 4. Repurchasing its own stock
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CHAPTER 6 EQUITY VALUATION
How much is a company worth? The methods in this chapter shed light on this perplexing question deciding how much to pay for a share of a company, the whole company if you are buying, or how much to ask for if you are selling. If there is a market price from a stock exchange, over-the-counter trading, or a recent transaction of a privately held company, you have a starting point for an analysis. This chapter explains two models, the free cash flow model and the market multiples model. They purport to measure fair value, also called intrinsic value, which may or may not be the same as market price. Notice the distinction in terminology: market price and fair value. We know the price because it comes from an actual transaction in a market place. We know value based on the calculations in a model.
Learning Objectives: 1. Understand the foibles of equity valuation. 2. Appreciate that the capital budgeting analysis in Chapter 5 uses free cash flow to value one project alone. To refresh your memory, use the flow diagram below to check the green boxes depicting capital budgeting analysis. The analysis in this chapter values the whole business - all the projects, not just one alone using similar methodology based on free cash flow. 3. Realize that market price is not the same as fair value. 4. Learn how to use, and not abuse, the free cash flow and market multiples equity valuation models.
The blue boxes in the Flow Diagram depict the two valuation models discussed in this chapter, Free Cash Flow and Market Multiples. Notice that the Free Cash Flow Model depends on k wacc for its discount rate. After the equity value is calculated using one or both of these models, that value is used as an input in the financing decision, in the red boxes. Financing is covered in Chapter 7.
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Similarly, check the IS/BS Model on the next page to make sure you are keeping track of how the analytic tools fit together. Here we are dealing with the blue block in the IS/BS Model. Notice that the valuation equation portrayed there, cash flow divided by cost of capital, is a simple equation that capitalizes cash flow to estimate value. The valuation models presented in this chapter provide a more complex, more realistic valuation methodology based on cash flows over time rather than a single-period cash flow.
Market Price vs. Value
Recall the distinction between price and value; they are not equivalent. Market price is the amount of money paid when shares are exchanged. A companys share, priced today at $15.25, may be priced next month at $12.00 or $19.50, or lower, or higher. Two months ago it may have been priced at $8.00 or $22.25. Fair value is the intrinsic worth of a company, based on its ability to generate cash flow for its owners, apart from the temporary market forces that determine its market price on any particular day. For this reason, you should not expect the results of a valuation analysis to be equivalent to the market price on any given day.
The analysis here assumes a going concern; meaning that cash flow generated by an operating business, a going concern, determines its value. Before the discussion of going concern value gets started, it is useful to define three other measures of value:
Book value is another term for equity, the figure on the balance sheet. Book value per share is equity divided by the number of shares issued. Because the dollar amount of equity is based on the amount of money received when shares were newly issued, plus profit reinvested in the business (retained earnings), there may be no logical relationship between book value, price, and value.
OP & CAP NATCF, NPV, IRR, PAYBACK K-WACC ENTERPRISE VALUE USING FREE CASH FLOW MARKET MULTIPLES: P/E, MV/BV, REV, EBIT
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Liquidation value is the amount of money that could be raised if all assets were sold, less total liabilities.
Replacement value is the amount money it would require to replace, at current market prices, the assets of a business, less total liabilities.
Valuing shares of a company is a combination of art and science. You use a model that has the appearance of a precise scientific approach, but deciding which numbers go into the model requires artistic forecasting based on judgment and experience. It is useful to determine a range of possible values, rather than looking for an exact value. Then, a negotiation process between the parties involved in a deal narrows the range until agreement about a price is reached. If no negotiation process is involved, you can simulate one by posing the differing viewpoints of potential buyers and sellers. Sellers assume a best-case scenario; buyers do the reverse. Human nature dictates that sellers want to sell at the highest possible price; buyers want to buy at the lowest possible price.
Develop a questioning mode of thinking about the valuation process and learn to combine all of the involvedto approach this valuation process with a combination of artistic and scientific judgment.
The Purposes of Estimating Fair or Intrinsic Value Determine if the market undervalues or overvalues your shares Value a sale or purchase of all or part of a business either for cash or for shares or a combination of cash and shares Set an offering price for shares in an initial public offering (selling newly-issued shares) or secondary offering (selling already-issued shares) Set the terms of exchange and/or cash investment in privatization, joint-venture, or buyout deals
90 Chapter 6 opens with comments about the validity of the valuation process, so you can think about its foibles from the outset. Too many finance professors and textbooks take valuation too literally by accepting the modeling results without question. Modeling appears to be scientific, but it is not. There is a lot of art behind it. Please keep this notion in mind as you go through the material here.
The slight of handlegerdemain poster invites you to think of valuation as something manipulated by a showman. Is that going too far? Is equity valuation beauty in the eye of the analyst beholder? Yes! How can you escape that conclusion when you realize that skilled, knowledgeable analysts have different opinions about value.
Read on, about Skype and Google. The Skype deal is one of the classics, $2.6 billion paid in 2005 for a company with no profits. Google mounted a notorious Initial offering, also in 2005.
Below are two press clippings about Skype. The first one reports the eBay purchase of Skype in 2005, highlighting consternation about the $2.6 billion valuation, taking note of: Transaction price being compared to value. Use of financial ratios. Use of comparables from businesses judged to be peers. Use of forecasted revenue and expense The second one reports the prediction that Skype could be worth twice its 2010 valuation of $2.75 billion. As you read, wonder about where these valuations come from: thin air - market hype, rigorous analysis.
1-eEBay Draws Skype Skeptics (excerpts): By Mylene Mangalindan, The Wall Street Journal, October 3, 2005 Wall Street is wondering just how eBay Inc. will get its $2.6 billion acquisition of Skype Technologies SA to pay off. Citigroup Inc. analyst Mark Mahaney says he can justify only half of the deal's $2.6 billion price tag. Mr. Mahaney, who rates the stock "buy" and doesn't own eBay shares, calculates that if Skype produces 2006 revenue of $200 million and generates a 25% earnings margin before interest, taxes, depreciation and amortization, Skype's earnings will total $50 million. If $50 million is multiplied by a 25-times multiple -- the number that was used to value other Internet deals such as eBay's purchase of Shopping.com and IAC/InterActive Corp.'s acquisition of Ask Jeeves -- that results in a $1.3 billion value.
91 Mr. Mahaney acknowledges, however, that there may be "material synergies" between eBay and Skype, considering Skype has 54 million global users to add to eBay's 157 million registered users and 79 million PayPal accounts. But, he adds, the deal's valuation requires "aggressive assumptions." Rajiv Dutta, eBay's chief financial officer, says Skype is a great stand-alone business, one that benefits as more people join the network. He says the proper context for valuing Skype is by comparing it to eBay and PayPal at the same stage in their development. After two years of generating revenue, Skype's projected revenue of $60 million this year beats the $47 million eBay generated at the same point in its life, though it falls short of the $100 million that PayPal was producing in its second year. By some measures, eBay is paying less for Skype than it did for other deals, Mr. Dutta says. By shelling out $2.6 billion for Skype's 54 million customers, the Internet auctioneer is spending $55 for each Skype customer, less than the $80 it paid for each PayPal customer, he notes. In addition, the Skype purchase is 4.8% of the eBay's market value of $55 billion, while PayPal was 8%. Mr. Dutta concedes that investors may have a hard time justifying the deal's valuation because the business eBay is building with Skype "doesn't in fact exist" yet. He says the company plans to gain revenue by layering other services that consumers will have to pay for on top of Skype's technology. At least one Wall Street analyst is on eBay's side. Anthony Noto, a Goldman Sachs Group Inc. analyst, says Skype can help eBay generate revenue from the 1.9 billion monthly searches that take place on its sites by posting pay-per-call sponsored listings, or paid advertising, on the top of search-results pages. Mr. Noto, who rates the stock "outperform" and doesn't own eBay shares, estimates eBay can produce $365 million to $900 million in incremental revenue a year through such listings with the calls priced at $2 to $5. By applying a 60% operating margin and a 40% tax rate, he calculates eBay's potential sponsored listings revenue will yield incremental net income of $130 million to $325 million. 2-Skype on Deck by Robert Cyran and Rob Cox, Considered View (online), March 15, 2010 the former eBay orphan could steal the scene with a quick flip. After clarifying copyright issues and rewriting its code to attack the business market, the internet telephony group may be worth twice the $2.75 billion it sold for last year. Now, read about Google. The first panel of data comes from its initial public offering on August 19, 2004 at $85 per share, giving it a market capitalization of $23.1 billion the market price on that day of all the common stock outstanding.
92 No matter how hard Googles managers and advisers tried to market their initial public offering at the best possible price, it sold at $85 per share, a relatively low price compared to what they had in mind. Was this a mistake? How much money did they leave on the table, if they could have gone to market at $100 (the price of first secondary market trade after the primary market IPO), or $125, or $150? According to a news report on July 26, 2004, Google set the price range at $108 to $135 per share. But, by the time August 19 rolled around, the IPO price was $85. How would you feel if you sold your company at $85 and then saw it rise to $100 the same day, and then nearly $400 in less than 18 months? Why cant equity valuation experts do a better job of forecasting (estimating/predicting), so Googles initial investors couldnt buy so cheaply? They cant. Its impossible. Its based in forecasting the unknown future. More than the future performance of the company is involved. Other factors include: performance of the economy, performance of the industry and peer companies, performance of the overall market, and investor attitudes about risk taking.
From www.google-ipo.com
IPO Date: August 19, 2004 First Trade:11:56 am ET at $100.01 Price: $85.00 Method: Modified Dutch Auction Lead Underwriters: Morgan Stanley, Credit Suisse First Boston Stock Symbol: GOOG Exchange: NASDAQ No. of Shares Offered: 19,605,052 Value of Offering: $1.67 billion Initial Market Cap: $23.1 billion Total Initial Shares Outstanding: 271.2 million (33.6 mil. class A, 237.6 mil. class B)
From http://finance.yahoo.com/q/bc?s=GOOG
93 As of November 2, 2005, Googles market price per share was $379.29 (P/E ratio of about 84 times); its market capitalization was about $103 billion. For comparison, Wal- Marts market capitalization the same day was about $210 billion (P/E of about 18 times), a little more than twice as much.
Now look at the chart below showing Google on September 2, 2011, with a per share price of $524.85 (P/E ratio of about 19 times) and a market capitalization of about $170 billion. Wal-Marts market capitalization in the same day was about $179 billion, with a P/E ratio of about 11 times.
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Google as of September 2, 2011 http://finance.yahoo.com/q/bc?s=GOOG&t=my&l=on&z=l&q=l&c=
95 The table below summarizes the changes in Googles and Wal-Marts market capitalization and P/e ratios:
Name 2004 2005 2011 Google $23 billion $103 billion 84 x earnings $170 billion 19 x earnings Wal-Mart NA $210 18 x $179 11 x
As its market capitalization grew from $103 to $170 billion, Googles P/E came back to earth in 2011 to a reasonable level of 19 times from 84 times in 2005. Wal-Marts market capitalization fell from $210 to $179 billion, as its P/E fell from 11 to 11 times earnings. Will Googles future value justify its current price? Is Wal-Mart on the decline, even though it is one of the largest companies in the world?
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Similarity of Free Cash Flow in Capital Budgeting and Equity Valuation
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 41 42 43 44 45 46 47 48 49 50 51 52 A B C D E F G Year 0 1 2 3 4 5 Units sold 0.0 0.0 0.0 0.0 0.0 Sales price per unit 0.0 0.0 0.0 0.0 0.0 Sales revenue 0.0 0.0 0.0 0.0 0.0 Less: variable cost of good sold 0.0 0.0 0.0 0.0 0.0 Less: fixed cost of goods sold 0.0 0.0 0.0 0.0 0.0 Less: variable GS&A expense 0.0 0.0 0.0 0.0 0.0 Less: fixed GS&A expense 0.0 0.0 0.0 0.0 0.0 Less: depreciation 1.0 1.0 1.0 1.0 1.0 Equals: total operating expense 1.0 1.0 1.0 1.0 1.0 Equals: EBIT -1.0 -1.0 -1.0 -1.0 -1.0 Income tax rate & income tax 0% 0.0 0.0 0.0 0.0 0.0 Operating cash flow: EBIT -1.0 -1.0 -1.0 -1.0 -1.0 Minus: Taxes 0.0 0.0 0.0 0.0 0.0 Plus: Depreciation 1.0 1.0 1.0 1.0 1.0 Equals: Operating cash flows 0.0 0.0 0.0 0.0 0.0 Change in Net Working Capital: Revenue 0.0 0.0 0.0 0.0 0.0 Cost of goods sold 0.0 #DIV/0! #DIV/0! #DIV/0! #DIV/0! Receivables (enter days in Column B) 0 0.0 0.0 0.0 0.0 0.0 Inventory (enter days in Column B) 0 0.0 #DIV/0! #DIV/0! #DIV/0! #DIV/0! Payables (enter days in Column B) 30 0.0 #DIV/0! #DIV/0! #DIV/0! #DIV/0! Net working capital needs 0.0 #DIV/0! #DIV/0! #DIV/0! #DIV/0! Liquidation of working capital 1.0 Investment in working capital 0.0 #DIV/0! #DIV/0! #DIV/0! #DIV/0! Free cash flow: Operating cash flow 0.0 0.0 0.0 0.0 0.0 Minus: Invesment in net working capital 0.0 #DIV/0! #DIV/0! #DIV/0! #DIV/0! Minus: Investment in PPE (CapEx) 0.0 0.0 0.0 0.0 0.0 0.0 Plus: Salvage value 0.0 Free cash flow 0.0 0.0 #DIV/0! #DIV/0! #DIV/0! #DIV/0! Cumulative free cash flow 0.0 0.0 #DIV/0! #DIV/0! #DIV/0! #DIV/0! Discount rate (K-wacc) 0% Net Present Value (NPV) #DIV/0! Profitability Index (PI) #DIV/0! Internal Rate of Return (IRR) #VALUE! Payback Period inspection of cumulative FCF - row 45 SECTIONS II AND III, IN ADDITION TO THE CHANGE IN CAPITAL SPENDING SECTION V. CALCULATE DECISION CRITERIA USING FREE CASH FLOW SECTION I. CALCULATE THE CHANGE IN EBIT, TAXES, AND DEPRECIATION (THIS BECOMES AN INPUT IN THE CALCULATION OF OPERATING CASH FLOWS IN SECTION II) enter data in blue-colored cells SECTION II. CALCULATE OPERATING CASH FLOW (THIS BECOMES AN INPUT IN THE CALCULATION OF FREE CASH FLOW IN SECTION IV) SECTION III. CALCULATE THE NET WORKING CAPITAL (THIS BECOMES AN INPUT IN THE CALCULATION OF FREE CASH FLOWS IN SECTION IV) SECTION IV. CALCULATE FREE CASH FLOW (USING INFORMATION CALCULATED IN
97 To refresh your memory, take a quick look at the Generic Capital Budgeting Template from Chapter 5, shown above. Recall how row 44, free cash flow, is calculated. You will find that it is exactly as stated in the equation above, via the Excel formula. Find this template in TemplateSet.xls, put your cursor on the cells in row 44, to see the formula that does the work.
(EBITTax Rate) + Depreciation +/- Change in Net Working Capital +/- Capital Spending = Free Cash Flow
In the sections below, you get a detailed look at the Free Cash Flow Model for equity valuation, realizing that FCF is the same in both models, Capital Budgeting and Valuation. Think if it this way: in capital budgeting, you value one project. In equity valuation, you value the entire business the methodology for both is very similar.
Basic Metrics
Two versions of the following basic formula is a good starting point for the discussion of value. Money is invested in a business for the purpose of generating cash flow going back to the investor. Rate of return is determined by the ratio of profit to investment, stated as a percentage. The proportion between the two is called rate of return. When you know how much investment is made, and how much annual cash flow is generated, the rate of return percentage can be calculated.
1- Cash Flow Investment = Rate Of Return
Now, turn the above formula upside down. Instead of knowing the amount of the investment, we know only the annual cash flow a business is capable of generating and the rate of return an investor wants to earn. Rearranging the terms in the formula, you get
2- Cash Flow Rate Of Return = Investment
Therefore, by dividing rate of return into cash flow, the result is the amount of money that can be invested to generate that amount of cash flow at that rate of return. This is called capitalizing a cash flow to determine the amount of the investment it justifies, given a rate of return. The figure in the denominator is called a capitalization rate, which is another way of describing the rate of return an investor requires before parting with his or her money.
This formula depicts the relationship between RATE OF RETURN AND RISK, a sacred concept in finance. It shows how value results when investors in the market place forecast cash flow and the possible variation in that cash flow. To investors, variation in cash flows means risk. With cash flow in the numerator of the formula, and with a rate of return percentage in the denominator acting as the proxy for the risk inherent in the cash flows the result is a value for the business inversely related to its risk. There is no more fundamental principle of finance than this one: RETURN VARIES INVERSELY WITH RISK. You can solve for rate of return knowing the cash flow and the amount invested, or, you can solve for how much to invest (value), knowing the cash flow and the desired rate of return.
98 The weighted average cost of capital, k wacc , as calculated in Chapter 5, was used as the discount rate in the capital budgeting procedure discussed in Chapter 5. It will also be used as the discount rate for the valuation procedure in this chapter. As you have noticed, the greater the riskiness of the business, as perceived by investors in the capital market, the higher will be their required rate of return, i.e., the discount rate they apply. You already know from Time Value of Money methodology that discounting cash flows at a higher rate givers a lower present value. Therefore, the riskier a business, all else the same, the lower its value, because its cash flows are capitalized at a higher required rate of return.
Dividend Discount Model (DDM)
The theoretical value of a share is the present value of the future dividends it earns.
Algebraically, where D 1 , D 2 through D n are dividends received by investors in perpetuity, and k is cost of equity, the discount rate representing the equity investor's required rate of return. The Dividend Discount Model (DDM) is an algebraic simplification of the above equation, assuming that the annual dividend, D, grows at a constant percentage g, and that the perpetual dividend flows are discounted at a constant percentage k:
V 0 = [D 0 x (1+g)] / (k g)
The current dividend per share is used as the starting point. The growth rate can be taken from past experience or set according to the judgment of the analyst. The discount rate is the cost of equity. Note that the model works only when the discount rate is greater than the growth rate. Simple as it seems, the DDM is the foundation of thinking about equity valuation, and many security analysts present DDM results along with results of the free cash flow model discussed next.
Internal Rate of Return (IRR)
The Apple IPO price on December 12, 1980 was $22.00 a share, which is $2.75 in todays shares on a split-adjusted basis. An investment in 1,000 shares for $22,000 would be worth about $2.9 million as of December 12, 2010, 30 years later. Using the IRR method, the investment in period 0 was -$2.75. The terminal price in period 30 is $320. The IRR is 17.8% per year over this 30-year period.
For Google, the August 19, 2004 IPO price was $85. The August 19, 2011 price was about $500. Therefore, the IRR for Google is 34.4% per year over this 7-year period; the Excel calculation is shown below. Performing these calculations correctly requires cash flows at annual intervals; thats why the terminal date is on the same day as the IPO, 7 years later. You must also make sure that the initial price is adjusted for any stock splits that took place between the initial date and the terminal date.
n n k D k D k D V ) 1 ( ..... ) 1 ( ) 1 ( 2 2 1 1 0 + + + + + + =
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Free Cash Flow Equity Valuation (FCF) Model
Financial analysts use the free cash flow model for estimating the fair or intrinsic value of a business. It is based on data from forecasted income statements and balance sheets, boiled down to free cash flow over a period of future years. The present value of these future free cash flow flows equals the value of the business. The discount rate used to calculate the present value of the free cash flows is the rate of return expected by investors, calculated as K-wacc.
Following is a step-by-step explanation of the valuation for Universal Industries, using the FCF Valuation Template shown below.
The term free is used to describe cash flow because it represents the cash flow remaining after investing in the assets, both NWC and PPE, needed to support the growth in revenue. These free cash flows are available to pay interest and repay principal to suppliers of debt, and are available to pay dividends to suppliers of equity, or to reinvest in the business. 7
7 For a growing company, it is not unusual to get negative FCF figures, because in most companies, CFFO growth is lower than the asset growth rate - especially when revenue is growing rapidly. This is the same thing as the result of the forecast in Chapter 3, external financing needed, the plug figure, because assets must equal liabilities plus equity. If a growing company has a positive free cash flow only in the last year of the forecast period, its terminal value will be positive. Since terminal value is a large component of enterprise value, share value will come out a positive number. When growth in revenue is eliminated from the forecast, the change in net working capital and capital expenditure rows become zero, and FCF increases, because CFFO is a positive number and there is no need to invest in more working capital and fixed assetsthe proverbial cash cow. You 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 A B C D E F G FREE-CASH-FLOW VALUATION OF EQUITY Assumptions: PERIOD 2011 2012 2013 2014 2015 2016 YEAR 0 1 2 3 4 5 Profit from operations (EBIT) 93.6 109.0 192.9 243.6 278.7 Income tax rate 15.6% 15.6% 15.6% 15.6% 15.6% Depreciation & amortization expense 65.4 65.4 65.4 76.7 76.7 Net working capital from balance sheet forecast 164.9 184.4 214.8 235.1 290.2 324.6 Capital expenditures 150.0 0.0 0.0 150.0 0.0 Long-term growth rate 5.0% Wt-Avg. C of C (K-wacc) 10.9% Market Value of Debt 413.1 Number of Shares 150.0 Redundant Assets 0.0 PERIOD 2011 2012 2013 2014 2015 2016 YEAR 0 1 2 3 4 5 EBIT after tax (EBIAT) 79.0 92.0 162.8 205.6 235.2 + Depreciation 65.4 65.4 65.4 76.7 76.7 =Cash Flow from Operations (CFFO) 144.4 157.4 228.2 282.3 311.9 +/- Change in Net Working Capital (19.5) (30.4) (20.3) (55.1) (34.4) +/- Capital Expenditures (150.0) 0.0 0.0 (150.0) 0.0 =Free Cash Flow (FCF) (25.1) 127.0 207.9 77.2 277.5 +Terminal Value (TV) 4939.0 =Sum of FCF + TV (25.1) 127.0 207.9 77.2 5216.5 Present Value 3393.8 - Market Value of Debt 413.1 = Valuation of Equity 2980.7 +Redundant assets 0.0 =Adjusted Value of Equity 2980.7 / Number of Shares 150.0 Value of Equity per Share ! 19.87
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Income statement entries. The starting point is the LONG FORM FORECAST MODEL (LFFM) from Chapter, or any other forecast you might have, entering data as follows: 1. Forecasted profit from operations (EBIT) from cells M18.Q18 in LFFM is entered in the assumptions panel of the FCF VALUATION template in C5.G5. Notice that money amounts are entered with zeroes omitted; be consistent in all entries throughout the template to avoid errors. 2. Income tax rate from H23.L23 goes to row C6.G6 3. Depreciation/amortization expense from M14.Q14 goes to row C7.G7 These three entries are a simple matter of transferring data from the forecast template or another source to the valuation template, rows 5-7.
Balance sheet entries. Next, from the forecasted balance sheet template, enter: 4. Net Working Capital (NWC) does not have its own line item in LFFM, so you must calculate it separately as the sum of receivables + inventory payables, the enter the NWC figures in B8.G8. The B8 number is not from the forecast; it is NWC for the most recent historical period, 2011. It must be entered in the base year column, column B, so incremental NWC can be calculated. A good way to calculate NWC is to find a row of empty cells in LFFM and perform the NWC calculation. 5. Capital expenditures is entered from H54.L54 in LFFM to C9.G9 in the valuation template; it is based on engineers estimates of new plant, property and equipment needed to achieve the revenue levels implied in the forecast, not PPE as a percentage of sales which is a crude and likely incorrect estimate of capital expenditure. Production can increase without investing in new PPE if excess capacity exists in the existing PPE as is the case in many businesses. If new PPE is required, the investment is based on how much it will cost, not a percentage of historical PPE. For an external analyst lacking internal data, capital expenditures is hard to forecast do the best you can.
Other data: 6. Enter a long-term growth rate in G10. The purpose of this growth rate is to calculate a terminal value for free cash flows that will occur beyond the forecast period, here 2016 in Column G. Standard valuation methodology uses a growing perpetuity formula to calculate the terminal value based on the free cash flow in G23 growing into perpetuity at the constant rate entered in G10. Therefore, the growth rate must be a sustainable rate for the very long-term future. Large annual growth rates are not sustainable. A typical growth rate is 2%-5%, depending on economic and industry characteristics, and the strategy of the business. The growth rate must be smaller than the discount rate, or the formulas in the valuation template will not work. If the business anticipates high growth rates, extend the year-by-year forecast for those years, in their own separate columns, until the growth rate normalizes. For the valuation of Universal, the growth rate in G10 was set a 5%. 7. Enter K-wacc in B10, either from the Cost of Capital template or an estimate from another source.
can see that a cash cow is a mature company with slow or no revenue growthit throws off cash because there is no need to invest is new assets.
101 8. Enter market value of long-term debt in B12, but you probably do not have market value data, so enter its book value from the most recent historical period in the balance sheet. Combine all rows listing long-term debt into a single entry. 9. Enter the number of common shares outstanding in B13. The correct figure to use is the number of shares outstanding at the end of the most recent historical period. Remember: authorized shares do not count; only issued shares count. Treasury shares are not issued shares; they do not count. Whether or not to use fully diluted or primary shares is a judgment call that you can make. Whichever one you choose, be consistent using the same number throughout your analysis. Be careful about omitted zeroes; make sure all entries throughout the template are consistent regarding omitted zeroes errors often result from inconsistencies. 10. Enter redundant assets, if any, in B14. This includes excess cash or any other asset on the books that is not needed to generate the revenue levels implied in the forecast, i.e., they could be sold off without any change elsewhere in the forecast. 11. The analysis is performed on rows 16-33, drawing data from the assumptions data you entered in rows 1-14. Free cash flow (FCF) is defined as the sum of cash flow from operations minus income tax minus change in net working capital minus capital expenditures. Note that the all data from the forecasted balance sheet template is not entered as it is it is transformed into the incremental investment in net working capital and plant, property, and equipment. It captures the year-to-year change, the new investment in the business required support the growth plan. As revenue changes, net working capital also changes spontaneously, which means that money must be invested in the business to support the revenue increase. Recall the discussion in Chapter 5 on Capital Budgeting, discussing the distinction between the year- end totals for NWC and PPE on the balance sheet, and the year-by-year incremental changes. You are measuring cash flows in this forecast; therefore the year-by-year incremental changes are the correct figures to enter. 12. This forecast uses a 5-year time horizon; no results are shown beyond 2016. Unless the business ceases to operate on that date and the liquation value of its net assets on that date is zero, something must be added to the cash flow analysis to represent what will happen in 2017 and beyond, namely, a terminal value. Terminal value is the present value of all cash flows from the year 2017 into perpetuity, i.e., a proxy for all the free cash flows that are expected to occur after 2016. A growing perpetuity formula is similar to the DDM, discussed above.
TERMINAL VALUE = [FCF n x (1+g)] / (k-g)
where g in cell G10 is a sustainable long-term growth rate of 5% and K wacc in cell B11 is cost of capital of 10.9%. Note that terminal value occurs at the end of 2016 because it represents the present value of the growing perpetuity from that period forward, shown in cell G24. Both the five FCFs and the one Terminal Value (TV) are discounted to present value at 10.9%. The sum of the present values, cell B27, is the enterprise value of Universal Industries. Enterprise value is the value of the business to all suppliers of permanent capital, debt investors and equity investors. 13. To determine the value of equity, the value of long-term debt in cell B28 is deducted from enterprise value. Therefore, the intrinsic value of equity, cell B29,
102 is viewed as a residual value of enterprise value, net of debt. Adjust it by adding redundant assets, if any. Then divide B31 by shares outstanding in cell B32 to get per share intrinsic value, cell B33. The resulting value of 19.87 EUR can then compared to the current market price, whatever it is, to determine if the company is overvalued or undervalued (and the percentage of over-valuedness or under-valuedness).
Complications
It is possible for Cash Flow From Operations (CFFO) to be negative, especially in early years of growth before projects reach profitability. If the business invests in net working capital and fixed assets during the same years when CFFO is negative, free cash flow will be negative. This should not be surprising because it is the normal condition of a growing business, absorbing more cash flow than it generates, requiring external financing, as seen in the forecast.
Change in net working capital can be a negative number (a cash inflow), indicating that revenue is declining and working capital needs are falling. Similarly, capital expenditure can be negative if fixed assets are divested. Keep careful track of the signs on these cash flows increases signify uses of funds decreases signify sources of funds.
More on Terminal Value
Point 12 above defined and explained the growing perpetuity formula as a proxy for terminal value in the Free Cash Flow Valuation Model. It is standard methodology. There are, however, other proxies to use instead of the growing perpetuity model. Which one to use, the standard method as explained above, or an alternative, is a matter of judgment by the analyst about which terminal value proxy best represents reality. Dont worry about it too much forecasts of cash flows from the 6 th year in the future into infinity are not easy to make. Keep in mind: if no terminal value is included in the forecast, the valuation will be based on the assumption that the business vaporizes at the end of the 5 th year that no cash flows occur from that point on.
1. The estimated liquidation value of the business at the end of year 5 is one alternative to the growing perpetuity method. The quickest way to estimate liquidation value is to use net worth, Q87 on the LFFM. If you want to do this, enter 0% as growth rate in G10 and enter liquidation value in G24 overriding the growing perpetuity formula in that cell. 2. A market multiple of revenue, EBIT, net income, or book value of equity is another alternative to the growing perpetuity method. Market multiples are discussed in the next section. If you want to do this, enter 0% as the growth rate in G10 and enter the result of the market multiple calculation in G24 overriding the growing perpetuity formula in that cell.
Market Multiples Equity Valuation Model
Financial analysts use the market multiples model as a substitute for, or as a supplement to, the free cash flow valuation model. Data from publicly held peer
103 companies in the same industry are used as a means of comparison. Market multiples are sometimes called comparables.
The free cash flow model does not claim to be a mirror for how the market values a company at a given time; it represents a belief about value based on parameters plugged into a template: cash flows, growth rates, and discount rates, generating a fair value, also called an intrinsic value, that can be above or below current market price.
Alternatively, application of market multiples on companies similar to the firm under analysis offer a more direct measure of prevailing market value if the peer companies are valid comparators and the data represent current market conditions (both conditions are often violated). The belief is, if a share of Company X stock, in the same industry as the business being valued, has a market price equal to 16 times its net income, then the company being valued should also sell at the same market multiple 16 times its net income
Calculate market multiples
Four types of market multiples are most commonly used. Each of them comes from a ratio, with the market price per share of the peer company in the numerator, and one of four parameters from the peer company in the denominator, generating the market multiple: 1. market price per share of peer company earnings peer share of peer company 2. market price per share of peer company revenue peer share of peer company 3. market price per share of peer company EBITDA 8 per share of peer company 4. market price per share of peer company book value of equity per share of peer company
Calculate equity value using market multiples
Then, using the market multiples as calculated above, each market multiple is multiplied by each of the four parameters of the company being valued, as follows: 5. Market multiple for revenue x revenue per share of target company 6. Market multiple for EBITDA multiple x EBITDA per share of target company 7. Market multiple for net income x earnings per share of target company 8. Market multiple for book value of equity x book value of equity per share of target company
The Market Multiples Valuation template is shown below.
1. Enter peer market multiples in A39.G42. There is room for five publicly held peer firms of Universal Industries, the target firm, labeled Peer A through Peer E. Usually the market multiples can be obtained from published sources. If the sources offer only one or two of the market multiples, not all four, its okay to leave the others blank, even though the analysis is less thorough. Alternatively, use peer financial statements and calculate the market multiples yourself, following the first 4 steps above a good idea because you control the numerator and denominator and know for sure how each multiple is derived. Find
8 If EDITDA data is not available, use EBIT and note the change in the Market Multiples Valuation Template.
104 share price data on Yahoo Finance; you can usually find market multiples there too. 2. Excel calculates the average of each market multiple in G39.G42. If you do not enter data for all five peers, adjust the function computing the averages, so you do not average in zero values. 3. Enter data for Universal, the target company, in A44.B49, from the LFFT or its historical financial statements. Multiples can be based on the most recent historical data, at the end of 2011 in this example, or on forecast data. Be conservative, use historical data, but be aware that analysts sometimes use forecast data instead. Entries in B45.B49 come from LFFM F8, F18, F27, F87, and F39. 4. A51.E57 shows the market multiples calculations done by Excel. First, notice that the target companys data are copied into B54.57. Second, notice that the average market multiples are copied into C54.C57. Next, the average market multiple is multiplied by target company data, column B times column C, giving the aggregate valuations in D54.D57. 5. E54.E57 divides column D by the number of shares in B49, giving the per share valuation. If you dont know the number of shares of the target company, thats okay. Stating the aggregate value of 100% of the shares tells you what you need to know.
The average of the four resulting values is 25.91 EUR per share, about 30% above the 19.87 EUR intrinsic value estimated from the free cash flow model. Notice that the results of the Free Cash Flow model and the Market Multiples model are not mutually confirming. The range of values suggested by the four different multiples is wide, from 12.89 EUR per share using Price/EBITDA market multiple to 42.43 EUR using Price/Revenue. With a current market price of 15.25 EUR at the end of 2011, we can draw the conclusion that Universal shares are undervalued. Only the EBITDA multiple suggests otherwise with its valuation of 12.89 EUR.
Reconcile Conflicting Results of Free Cash Flow and Market Multiples Models
This chapter began by warning you about the tentative nature of equity valuation. What might appear to be a scientific approach, using Excel modeling, is a highly subjective and impressionistic process where the analyst has wide discretion to decide about the 36 37 38 39 40 41 42 43 44 45 46 47 48 49 50 51 52 53 54 55 56 57 A B C D E F G MARKET MULTIPLES (COMPARABLES) VALUATION OF EQUITY Average Market Multiples of Peers Peer A Peer B Peer C Peer D Peer E Mkt Mult Price /revenue market multiple of peer company 4.0 5.0 6.0 10.0 1.0 5.2 Price/EBITDA market multiple of peer company 14.0 12.0 18.0 20.0 6.0 14.0 Price /Earnings market multiple of peer company 23.0 35.0 41.0 60.0 6.0 33.0 Mkt Val of Eq/Book Val mkt mult of Equity of peer co 5.0 8.0 10.0 14.0 1.0 7.6 Target company data Target company revenue 1224.0 Target company EBITDA 138.1 Target company earnings (net income) 105.3 Target company book value of equity 496.2 Target company number of shares 150.0 from col B from Col G BxC C/B55 Target Co Average Aggregate Per Share Valuation Calculations Data Mkt Mult Valuation Valuation Valuation based on avg revenue market multiple 1224.0 5.2 6364.80 ! 42.43 Valuation based on avg EBITDA market multiple 138.1 14.0 1933.40 ! 12.89 Valuation based on avg earnings market multiple 105.3 33.0 3474.90 ! 23.17 Valuation based on avg book value market multiple 496.2 7.6 3771.12 ! 25.14
105 inputs driving the valuation. You can picture the valuation analyst either as a scientist in a white lab coat, or as an artist, like the ones below.
Abstract Artist Don Tywoniw don2d@comcast.net www.2Dgraphics.net The table below arrays the results from both models and includes the current market price. If you throw out the extremes, 42.43 and 19.87, you are left with a cluster in column D averaging 24.74, a valuation that is 25% above the current market value. You can decide to trust this result or not, depending on your confidence in all the inputs you made to the models, and your general knowledge about the economy, industry, company, and financial markets. Valuation is not an easy job!
59 60 61 62 63 64 65 66 A B C D E F Summary map FREE CASH FLOW MODEL 25.91 REVENUE MARKET MULTIPLE 42.43 EBITDA MARKET MULTIPLE 12.89 EARNINGS MARKET MULTIPLE 23.17 BOOK VALUE MARKET MULTIPLE 25.14 CURRENT MARKET PRICE 19.87
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Nine Elements in the Equity Valuation Process A Summary
Following is a listing of the nine elements found in generally accepted equity valuation methodology. It revisits many of the topics already presented in this book. Use them to put the results of the FCF and Market Multiples models in perspective.
1. Nature and history of the business is the historical financial statements and ratios along with descriptions of the business, its products, markets, competitors, suppliers, managers, successes, failures, problems, opportunities, and plans. 2. Future outlook for the business is the forecasted financial statements based on perceived growth in the economy, which determines the growth in the industry, and therefore determines the growth for the company. This is called a top-down analysis because it starts broadly with macroeconomic factors and ends narrowly with company revenue, profit, and cash flow. These are the components of business risk, also called operating leverage, describing how variations in unit volume and revenue prices filter through cost of sales and operating expenses to determine changes operating profit. 3. Financial status examines financial risk, also called financial leverage, through debt and coverage ratios. It describes how changes in operating profit filters through interest expense, taxes, and number of shares outstanding to determine changes earnings per share. 4. Future earning capacity is the quality of the cash flow, i.e., its predictability and stability over time. 5. Dividend payment capacity is the desire and ability to continue to pay dividends. 6. Goodwill covers other factors such as brand names, competitive ability, market penetration, technological advantages and patents, and management skills that may have a bearing on value. 7. When shares are not publicly traded, recent private share transactions, if any, in the same company can be used as a guideline for valuation. If no recent transactions occurred, transactions in similar companies can provide guidelines in terms of discount rates, price/earnings multiples, and other valuation data. 8. Redundant assets that can be sold without influencing the ability of the business to generate its revenue and cash flow should be added to the equity value. 9. Control block transactions may involve premiums of 20% or more.
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CHAPTER 7 DEBT VS. EQUITY FINANCING & LEASE VS. BORROW-TO-BUY ANALYSIS
The Debt vs. Equity Decision
Financial Leverage and Debt Capacity
Now we examine how a business decides to obtain external financing from the capital markets, using either debt or equity. The key question is how much money can be prudently borrowed? Most businesses view their plant capacity as a resource not to be wasted there is little disagreement about that. They may also view their ability to borrow, their debt capacity, as a resource, believing that it should be used to its full extent, just like they want to use their plant capacity to its full extent.
The IS/BS Model shows you where this chapters material fits into the process of financial decision-making. The red boxes of the balance sheet show debt and equity; the red boxes of the income statement show the interest expense generated by debt; both are keyed to the red label FINANCIAL LEVERAGE.
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The red panels in the Flow Diagram depict the financing decision process consisting of three parts: 1. the spreadsheet debt vs. equity analysis 2. the EBIT chart 3. the six-element decision summary
CAPITAL BUDGETING OP & CAP NATCF, NPV, IRR, PAYBACK K-WACC VALUATION ENTERPRISE VALUE USING FREE CASH FLOW MARKET MULTIPLES: P/E, MV/BV, REV, EBIT
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Leverage is Gearing
In the picture below, the smaller gears drive the biggest one. The use of debt in a companys capital structure is called leverage because a small base of equity (analogous to the smallest gear in the picture) has debt financing added to it (the successively larger gears) to provide that allows it to buy assets so they can produce their product or service. In fact, in some countries, the United Kingdom among them, gearing is their term for financial leverage.
Financial Risk Means Default Risk
Using debt means that financial risk looms in your planning. If you don't borrow, there are no fixed interest payments to make and you don't have to repay any principal; there is no lender to force you into bankruptcy; there is no financial risk. But, no use of debt financing may be narrow-minded. By combining some debt financing with equity financing, the owners can earn a higher rate of return than with 100% equity financing alone.
If you decide to play it safe, don't borrow at all, or borrow less. If you want to be aggressive, borrow the maximum amount that lenders are willing to lend. Your potential rate of return will be higher, but so will your risk. Whatever you decide to do, you must understand the return/risk trade-off. You can eat well (high ROE & low coverage ratio) or sleep well (low ROE & high coverage ratio), but not both. Always remember that the leverage created by borrowing is a double-edged sword; the greater the proportion of debt relative to equity, the more ROE increases as EBIT rises in good times, and the more ROE decreases as operating profit falls in bad times.
A look at the Financial Ratios display from Chapter 3, below, shows you where the leverage ratios come from rows 118, 103-107, and 124. You can zoom to 175% or more or view it in Template Set.xls.
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The table below illustrates the risk-return trade-offs involved with financial leverage. Operating profit (EBIT) and total assets are the same in all examples, Companies A, B, and C. Companies B and C use 40 of debt and 40 of equity; with financing cost of 8 (8%), where Company A has zero debt financing and zero financing cost. The advantage of debt financing is that ROE changes from 25% for Company A to 35% for Company B when 50% debt financing is used, illustrating positive financial leverage. On the other hand, negative financial leverage is illustrated by Company C, when operating profit falls to 15 from 25, ROE drops to 15% when it would have been 25% in Company A with zero debt.
ROIC Is a Performance Metric Undistorted by Capital Structure Policy (Financing)
Examine three ways to measure rates of return in the table below: ROE, row 15 ROA, row 16 ROIC, row 17
ROE rises from 7.2% with zero debt to 18.0% with 900 debt, although the 9:1 debt-equity ratio can be considered extreme. The numerator deceases because of interest expense, but the denominator decreases proportionally more.
COMPANY A B C Revenue 100 100 100 Operating profit (EBIT) 25 25 15 Financing cost 0 8 8 Profit before tax 25 17 7 Tax 5 3 1 Net profit 20 14 6 Total debt 0 40 40 Total equity 80 40 40 Total debt + equity 80 80 80 Return on equity 25% 35% 15% 95 96 97 98 99 100 101 102 103 104 105 106 107 108 109 110 111 112 113 114 115 116 117 118 119 120 121 122 123 124 125 A B C D E F G H YEAR 2010 2011 TREND PRELIMINARY INTERPRETATION NUMERATOR DEMONINATOR Liquidity Ratios Current ratio 1.6 1.3 -21% negative, less liquidity current assets current liabilities Quick ratio 1.1 0.8 -21% negative, less liquidity curr assets-inventory current liabilities Days sales in receivables 75.4 56.3 -25% positive, quicker collections receivables revenue/365 days Days cost of sales in inventory 59.9 54.0 -10% positive, faster turnover inventory cost of sales/365 days Days cost of sales in payables 47.6 65.0 37% negative, paying more slowly payables cost of sales/365 days
Leverage Ratios Long-term debt to total capital 57.9% 45.5% -21% positive, less financial risk l-t leases+loans+debt l-t leases+loans+debt+equity Long-term debt to equity 137.4% 83.5% -39% positive, less financial risk l-t leases+loans+debt equity Times interest earned 1.8 3.8 109% positive, better coverage operating profit (EBIT) finance costs Full burden coverage 1.5 3.1 107% positive, better coverage oper profit + lease exp finance costs + (lease exp/[1-tax rate])
Efficiency (Asset-Use) Ratios Fixed asset turnover 1.2 1.4 19% positive, faster turnover revenue total non-current assets Total asset turnover 0.8 1.0 21% positive, faster turnover revenue total assets
Profitability Ratios Gross margin 23.9% 34.9% 46% positive, big improvement gross profit revenue Operating profit margin 6.8% 11.3% 65% positive, bigger improvement operating profit (EBIT) revenue Return on sales 2.7% 8.6% 216% positive, still bigger improvement net profit revenue Return on total assets(ROA) 2.2% 8.5% 283% positive, still bigger improvement net profit total assets Return on equity (ROE) 6.8% 21.2% 212% positive, big improvement net profit equity Return on invested capital (ROIC) 4.7% 9.4% 100% positive, big improvement EBIT*I1-tax rate) total assets
DuPont Formula - ROE 6.8% 21.3% 212% profitability x efficiency x leverage Profitability 2.7% 8.6% 216% positive, big improvement net profit revenue Efficiency 0.8 1.0 21% positive, better turnover revenue total assets Leverage 3.1 2.5 -19% positive, less financial risk total assets equity ROE Check 6.8% 21.2% 212% calculation check to verify row 121 net profit equity
111 ROA decreases from 7.2% with zero debt to 1.8% with 900 debt, because interest expense reduces the numerator and has no impact on the denominator.
ROIC is the same, 7.2%, no matter how much of how little debt financial is used, because interest expense and equity are not part of the calculation.
When you need a rate of return metric that is independent of the financial structure of the business, use ROIC. It removes the distortion in the ROE and ROA metrics.
The Leahy Bread Company Case
The standard financing decision uses the forecasted external financing required combined with an analysis to determine whether that financing should be raised with debt or equity. Lets dig into the analysis using the fictional example of Leahy Bread Company (LBC).
Learning objectives: 1. Perform the debt versus equity analysis as depicted in the Flow Diagram 2. Prepare and interpret an EBIT chart highlighting the indifference level of EBIT 3. Determine the debt capacity 4. Consider the numerous, sometimes conflicting elements in the financing decision as summarized by the FRICTO acronym income, risk, control, marketability, flexibility, and timing. 5. Make the debt vs. equity decision
The LBC forecast below results in external financing need (EFN) of $392,675 (F79 of the forecast) to fund a major expansion plan. There are two ways to raise the money: 1. a 9% bond, with a 20-year maturity, and a balloon payment of $392,675 at maturity 2. a stock issue of 3,927 shares at $100 per share.
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 A B C D E F Interest rate 10% 10.0% Tax rate 40% 40.0% COMPANY A COMPANY B Debt 900 0 Equity 100 1000 TOTAL ASSETS 1000 1000 EBIT 120 120 - Interest expense 90 0 Earnings before tax 30 120 - Tax @ 40% 12 48 Earnings after tax 18 72 Numerator Denominator ROE 18.0% 7.2% RETURN ON EQUITY Earnings after tax Equity ROA 1.8% 7.2% RETURN ON ASSETS Earnings after tax Total Assets ROIC 7.2% 7.2% RETURN ON INVESTED CAPITAL EBIT * (1-Tax rate) Total Assets
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What comes next shows you, one step at a time, the financing decision process as depicted in the red boxes on the Flow Diagram: 1. find EFN 2. complete the financing spreadsheet 3. interpret the EBIT chart 4. determine the indifference point 5. measure the debt capacity 6. consider FRICTO elements 7. make the decision
The Financing Template is shown below; it evaluates the two financing alternatives, debt or equity. It is much simpler than it looks at first glance. The template creates a set of mini income statement forecasts, two for each of the two financing alternatives, debt and equity, one under a boom scenario and the other under a bust scenario.
49 50 51 52 53 54 55 56 57 58 59 60 61 62 63 64 65 66 67 68 69 70 71 72 73 74 75 76 77 78 79 A B C D E F 2012 2013 2014 2015 2016 Revenue 1,155,000 1,270,500 1,524,600 1,981,980 2,576,574 Costs of Goods Sold Bakery Caf 750,750 825,825 990,990 1,288,287 1,674,773 Dough Sold to Franchisees 138,600 152,460 182,952 237,838 309,189 Depreciation 57,750 63,525 76,230 99,099 128,829 General and Administrative (c) 92,400 101,640 121,968 158,558 206,126 1,039,500 1,143,450 1,372,140 1,783,782 2,318,917 Operating Profit (EBIT) 115,500 127,050 152,460 198,198 257,657 Interest Expense 21,000 21,000 21,000 21,000 21,000 Pretax Profit 94,500 106,050 131,460 177,198 236,657 Tax 33,075 37,118 46,011 62,019 82,830 Net Income 61,425 68,933 85,449 115,179 153,827 Current Assets 196,350 215,985 259,182 336,937 438,018 Property, Plant, and Equipment 485,100 533,610 640,332 832,432 1,082,161 Goodwill and Other Assets 115,500 127,050 152,460 198,198 257,657 Total Assets 796,950 876,645 1,051,974 1,367,566 1,777,836 Current Liabilities 138,600 160,962 193,154 251,100 326,430 Deferred Rent and Other Liabilities 46,200 59,296 71,155 92,501 120,252 Total Liabilities 184,800 220,258 264,309 343,602 446,682 Debt 0 0 0 0 0 Equity 515,091 584,024 669,473 784,651 938,479 Total Liabilities and Equity 699,891 804,281 933,782 1,128,253 1,385,161 EFN 97,059 72,364 118,192 239,313 392,675
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Follow these steps to perform the analysis.
1. Enter EFN from F79 in the forecast to B3 in the financing template. The forecast is shown above. 2. Enter existing number of shares, 7,500, in B4. Use the number of shares outstanding at the end of the most recent historical period. 3. Enter 300,000 existing long-term debt in B5. Use the most recent historical amount. 4. Enter in B6 the interest rate on the amount of long-term debt in B5. It can be estimated by dividing interest expense by long-term debt as long as there is no short-term debt. Alternatively, the company annual report reveals the interest rate. Use the most recent historical time period. 5. Enter the interest rate on prospective new debt in B7. It is given. 6. Decide what the lowest and highest possible levels of EBIT will be over the planning horizon; to identify the boom and bust extremes of EBIT. They are the same for both financing alternatives, entered in B8 and B9 using rounded arbitrary numbers below the lowest EBIT and above the highest EBIT figures from the LBC forecast on row 59. (If the EBITs you enter have too narrow a range between the high and low, the EBIT chart will not display the necessary range of numbers more on this is discussed later.) 7. Enter the income tax rate, 35%, in B10, using the most recent historical data. 8. Enter current share price in B11. 9. Enter stockholders equity in B12 from the most recent historical time period.
Results are automatically calculated by formulas in the template. Notice the mini income statements that are calculated, especially that: 10. Existing (old, before new debt financing) interest expense on row 17 is the same for all four scenarios. Only the debt scenarios have new interest expense, on row 18. 11. The existing number of shares on row 22 is the same for all four scenarios. Only the equity scenario has new shares, on row 23. New (after new equity financing) 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 A B C D E F FINANCING (DEBT-EQUITY) DECISION Leahy Bread Company Inputs: External Financing Needed 392,675 from forecast Existing Common Shares 7,500 from company info Existing Long-Term Debt 300,000 from most recent historical balance sheet Interest on Existing Debt 7.0% from company info Interest Rate on New Debt 9.0% given Boom EBIT 300,000 arbitrarily above optimistic forecast Bust EBIT 50,000 arbitrarily below pessimistic forecast Income Tax Rate 35.0% from income statement Share Price 100.00 $ from market info Equity 528,741 from most recent historical balance sheet Results: IF DEBT IS USED IF EQUITY IS USED BOOM BUST BOOM BUST EBIT 300,000 50,000 300,000 50,000 Interest expense - old (21,000) (21,000) (21,000) (21,000) Interest expense - new (35,341) (35,341) 0 0 Profit before tax 243,659 (6,341) 279,000 29,000 Income tax (85,281) 2,219 (97,650) (10,150) Net profit 158,379 (4,121) 181,350 18,850 Shares 7,500 7,500 7,500 7,500 Shares - new 0 0 3,927 3,927 Earnings per share 21.12 $ (0.55) $ 15.87 $ 1.65 $ Coverage ratio 5.3 0.9 14.3 2.4
114 number of shares on row 23 is the amount of money raised divided by the expected issue price of $100 per share. 12. The debt ratio is calculated by (old + new debt) divided by (old + new debt + equity). 13. The coverage ratio is calculated by EBIT divided by total interest (old + new).
EBIT Chart
Excel creates an EBIT Chart using some the data calculated in the 12 steps above:
It plots EBIT on the horizontal axis and EPS on the vertical axis. A wide-enough range between low and high EBIT is necessary; otherwise, the lines will be truncated and the point where the two lines cross, called the indifference level of EBIT, will not be displayed. Its easy to draw an EBIT Chart by hand, so you see exactly where it comes from: 1. plot low EBIT and debt EPS 2. plot high EBIT and debt EPS, then draw a line between the points the debt line 3. plot low EBIT and equity EPS 4. plot high EBIT and equity EPS, then draw a line between the points the equity line
Notice that the debt line is steeper than the equity line because use of debt financing causes EPS to change at a greater rate as EBIT changes the essence of financial leverage. Notice also the double-edged sword aspect of financial leverage as the lines diverge from the indifference level the gap between EPS with debt and EPS with equity widens. The right-hand divergence is good - financial leverage helps. The left-hand divergence is bad financial leverage hurts.
EBIT CHART ($5.00) $0.00 $5.00 $10.00 $15.00 $20.00 $25.00 50000 300000 EBIT E P S debt EPS equity EPS
115 There is no time dimension involved in creating the EBIT Chart. No specific year is specified. Its purpose is to display the EBIT-EPS relationship for any level of EBIT in any year.
Indifference point
The indifference point is the amount of EBIT where EPS is identical, whether the new financing comes from debt or equity. Interpret this narrowly company managers and owners will not be indifferent about the other FRICTO elements of the decision, discussed below. Indifference in the context of the EBIT Chart relates only to EBIT driving EPS.
The numerical indifference point can be guestimated by looking at the EBIT Chart. A more accurate indifference point is calculated in the table below:
The indifference point is EBIT of $123,841 giving earnings per share of $5.85 for both the debt and the equity scenarios. 9 From the forecast on page 112 at the beginning of this section, you can see that the EBIT ranges from $115,500 to $257,657. The indifference EBIT is about 7% above the low EBIT, and about 123% below the high EBIT. Interpreting the result depends on the probabilities of future EBITs falling either above or below $123,841. If managers believe that most-likely EBIT will be comfortably above the indifference level, the EBIT chart tells them to use debt financing, and vice versa. Remember: only the EBIT and EPS elements of the financing decision are considered here. The other FRICTO elements are discussed below. Keep reading!
Debt Capacity
How much debt can a business carry? Getting to the answer, which is a matter of opinion to some extent, is deceptively simple, using the model below:
9 The indifference level can be found using the FINANCING template alone by trial-and-error. Enter amounts for Bust EBIT until you get the same earnings per share results for both debt and equity alternatives. 48 49 50 51 52 53 54 55 56 57 58 59 A B C D E Indifference point calculation: Debt Equity Common shares 7,500 11,427 Income tax rate 35.0% 35.0% Interest expense 56,341 21,000 EBIT 123,841 123,841 Indifference EBIT Interest expense 56,341 21,000 EBT 67,500 102,841 Income tax 23,625 35,994 EAT 43,875 66,846 EPS 5.85 $ 5.85 $ Indifference EPS
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Follow this step-by-step example: 1. A range of EBITs is entered in row 64, using bust, boom and indifference levels. 2. Enter 5.9 in row 65 because managers decide to plan for a BBB credit rating, which carries an interest coverage ratio of 5.9 times according to this table:
3. In row 66, Excel plugs the EBIT and interest coverage numbers into the interest coverage formula: EBIT divided by interest expense equals coverage ratio. The result is the amount of money that is available to pay interest expense. 4. In row 67, enter the 9% interest rate given. If none is given, use a current rate that matches the credit rating chosen. 5. In row 68, using the interest rate on BBB-quality debt of 9% per year, Excel divides 9% into the amount available for interest (grossing it up). The result is the debt capacity of the business the amount of borrowing that can occur based on EBIT, the coverage ratio, and the interest rate. Of course, different inputs give different results thats why the measuring debt capacity is subject to opinion about which inputs should be used. 6. Enter in row 69 the amount of existing long-term debt from the most recent historical balance sheet. 7. In row 70, Excel subtracts existing long-term debt from overall debt capacity to get the amount of excess debt capacity, how much is available for new debt financing. A negative number means that debt capacity is exhausted, because existing debt exceeds overall debt capacity, i.e., the business has already borrowed too much.
All calculations above assume that only interest expense is paid each year that no principle payments are paid. If both principal and interest must be paid each year, the calculation becomes more complex debt capacity becomes the present value of an annuity where the periodic payment is the EBIT available to pay it, considering the coverage ratio required, adjusted for the fact that interest expense is paid in pre-tax dollars and principal is repaid in after-tax dollars. For example, if the tax rate is 35%, and the principal payment is $10,000, it takes $15,385 of EBIT to pay $10,000 of principal, $10,000 divided by (1-.35). Because EBIT is paid from pre-tax dollars, $10,000 of EBIT is needed to pay $10,000 of interest.
67 68 H I J K L M N O AAA AA A BBB BB B CCC Interest coverage ratio 27.3 18 10.4 5.9 3.4 1.5 0.5 62 63 64 65 66 67 68 69 70 A B C D E F Debt capacity calculation: Bust Boom Indiff. EBIT 50,000 300,000 123,841 Interest coverage ratio per rating 5.9 5.9 5.9 BBB rating chosen AVAILABLE FOR INTEREST 8,475 50,847 20,990 Interest rate 9.0% 9.0% 9.0% DEBT CAPACITY 94,162 564,972 233,222 Existing debt 300,000 300,000 300,000 EXCESS DEBT CAPACITY -205,838 264,972 -66,778
117 It is easy to estimate the debt capacity of a business, even though the resulting number is best interpreted as an approximation. Whether decision makers want to push debt to the limit, or use it conservatively, is a choice they have to make based on their confidence in the financial forecasts and their appetite for risk, as well as the full set of FRICTO elements in the financing decision, to be discussed next.
Summarizing the LBC financing decision with FRICTO
In making a decision about which financing alternative to use, the results in the financing template are interpreted by considering the trade-offs between these six elements in the financing decision. Using the first letter of the alphabet for each element, we get the acronym FRICTO (marketability as other): 1. flexibility 2. risk 3. income 4. control 5. timing 6. marketability: 10
The flexibility element deals with two things: 1. First, and easiest to appraise, are restrictive covenants and repayment schedules included in the loan contract. For instance, diverting cash from research and development or plant modernization to payment of principal may not be desirable. Also, restrictive covenants on levels of net working capital, purchase of assets, and payment of dividends limit the freedom of management action. Violation of any covenant may place the loan contract in default. 2. The second type of flexibility deals with the belief that the financing taking place now will not be the last one for this company, as it continues to grow. If it decides to use debt now, its debt ratio rises and coverage ratio fall. Then, the next time it needs external financing, equity may be the only choice because it may have exhausted its capacity to borrow. If the market price of its shares is falling, issuing equity would cause too much dilution of EPS and control. It would be a mistake if the financial managers forced themselves to use equity financing in the future, without realizing the possible adverse consequences in advance. There is nothing wrong with following an aggressive financing policy, using debt financing, but managers should always consider present external financing needs in the perspective of ongoing external financing needs.
The marketability element deals with the ability to sell the debt or equity securities to investors. The terms of the issues must be acceptable to the marketplace. Investors judge whether the rate of return they expect to earn is consistent with the risk involved and with the rates of return available on similar securities.
The timing element deals with market trends. Ideally, new permanent borrowing would occur when interest rates are historically low, and a new equity issue would occur when prices are historically high. As difficult as it is to do, the decision maker must consider the current interest rate environment in relation to an interest rate forecast, and decide if the company can accept fixed rate financing now. It may be possible to add a refinancing clause to the debt contract, allowing for the right to repay principal before the maturity date
10 The FRICTO analysis was developed by finance professors at the Harvard Business School in the 1960s.
118 without penalty if interest rates fall. It could then issue new debt at a lower interest rate, replacing the higher-rate debt. Of course, by insisting on the right to refinance, marketability of the issue may be reduced. Many investors are wary of refundable debt instruments because they are forced to reinvest at lower interest rates.
The control element deals with voting rights. If an equity issue places a controlling interest in jeopardy, debt may be considered as better than equity. In small companies, this factor is given a great deal of weight. You should be careful about allowing the control factor alone to push you in the direction of a debt financing decision. It may be short-sighted to incur the risk of debt financing when avoiding dilution of control is the only reason for it.
The income and risk elements are interpreted from the EBIT Chart, discussed above, and interest coverage ratios in the financing template. You already know that EBIT drives EPS, therefore, the steepness of the lines depends on the extent of financial leverage used, portraying the magnified impact on EPS that occurs when EBIT increases or decreases.
The income element is measured with EPS. Assuming a boom level of EBIT, EPS is highest for debt and lowest for equity. The reverse is true assuming a bust level of EBIT. The intersection of the two lines, called indifference point, shows the level of EBIT where earnings per share is identical whether debt or equity financing is usedall other things equal, it makes no difference whether debt or equity financing is used at this EBIT level because EPS is the same either way. Moving to the right of the indifference point, EPS for the debt scenario is greater than that for the equity scenario. Moving to the left of the indifference point, the reverse is true. Therefore, by identifying the most likely level of EBIT in the future, the decision maker can tell which financing alternative offers better EPS. The greater the spread between the debt and equity lines, depending on their relative steepness, the greater is the impact of financial leverage. Always remember: Leverage is a double-edged sword; it cuts two ways. To the right of the indifference point, financial leverage is beneficial all other elements equal. To the left of the indifference point, it is detrimental.
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The table below puts the sometimes-conflicting signals from the FRICTO analysis in one place. Some elements favor debt; others favor equity.
Decision Elements Metric Debt Financing Equity Financing Flexibility Future EFN Lower favors equity More favors equity Risk Slope of lines on EBIT Chart & indifference point, interest coverage ratios, excess debt capacity available, dilution of EPS Greater favors equity Lesser favors equity Income EPS, slope of lines on EBIT Chart & indifference point Greater favors debt Lesser favors debt Control Dilution of voting control Minimal dilution favors debt
Significant dilution favors equity Timing Current interest rates & stock price relative to trends Reasonable interest rate relative to trend favors debt Undervalued stock price favors debt (O) Marketability Terms of debt and equity issue and investors interest Willingness of debt investors to buy the issue Willingness of equity investors to buy the issue
Play the findings of each of the six elements off of one another. Could EBIT in the future easily fall below the $123,841 indifference level? One manager might prefer equity instead of debt a conservative, risk-averse recommendation. Another might use exactly the same information and recommend debt because her forecast of future EBIT is more optimistic and wants to take a more aggressive stance. Look at the trend of EBIT in the forecast and consider the probability of it falling below $123,841. EBIT in 2012 is forecast at $115,500, below the indifference point; 2016 EBIT of $257,657 is above the indifference point. How many years before EBIT exceeds the indifference level? According to the forecast about one year. But, by 2016, EBIT is more than double the indifference level, where on the low end, it is only about 8% below the indifference level. If they trust the forecast, many managers would favor debt financing; especially those with an optimistic outlook and an aggressive attitude about risk. Those favoring the equity alternative might have a pessimistic interpretation of the forecast, having a conservative, risk-averse attitude. Obviously, the risk of default is higher with debt financing, confirmed by the coverage ratio of 0.9 times for the bust level of EBIT.
120 Flexibility is greater with the equity alternative because excess debt capacity is still available for the next round of financing, as LBC continues its growth strategy, another interpretation favoring equity financing. Excess debt capacity is negative for both the bust and indifference level scenarios, indicating that they already have too much debt. Debt financing almost always maintains the control position because if equity is issued, each existing shareholder owns a smaller percentage of the company after an equity issue than before, incurring dilution. Lets assume that investment bankers are equally able to sell a debt issue or a stock issue, so the marketability element is neutral. Considering timing, if a 9% interest rate on debt is considered a fair rate for the next 20 years, then the timing of a debt issue is favorable. Similarly, if the $100 issue price for the stock is on the high end of the stocks recent trading range, then the timing of the stock issue is favorable.
What is the correct decision? Should it be debt or equity financing? There is no such correct answer. It depends on judgment by the people involved in the decision, their interpretations of the analysis resting on the believability of the forecasted data, and their attitudes toward growth and risk. While there may be no correct decision, there is certainly a correct analysis. Competent managers are guided by a complete analysis laying out both upside and downside possibilities. There is nothing wrong about following a risky path if the possible downside is clearly understood when the decision is made.
Closing Comments: Cost of Debt vs. Cost of Equity
Chapter 5 discussed the use of Weighted Average Cost of Capital as the discount rate in capital budgeting model. Chapter 6 used Weighted Average Cost of Capital as the discount rate in the Free Cash Flow Equity Valuation model. That is depicted in the IS/BS Model where cost of debt and cost of equity come together to calculate k-wacc; and depicted in the Flow Diagram where the k-wacc panel is tied to the capital budgeting and equity valuation boxes.
Lender: From the viewpoint of the creditor, lending money to a company is a less risky investment than buying shares in that company. The lender is a creditor with a contractual right to receive a specific amount of interest at specific dates and to receive the face amount at the maturity date.
Owner: The shareholder is an owner, who benefits during good times and who looses during bad times.
Lender vs. Owner: Therefore, the lender requires a lower rate of return because he or she takes less risk in lending than the shareholder does in owning. A lower rate is used to discount cash flows going to lenders than the one used to discount cash flows going to shareholders. K-wacc represents the weighted average of two discount rates, one for lenders, the other for owners, so it is interpreted as an average rate of return that goes to both categories of capital suppliers, lenders and owners.
121 One warning must be cited at this point. There is little difficulty realizing that debt has a cost. This is the interest rate paid on an after-tax basis to borrow the money, k-d. But, does equity have a cost? After all, if no dividends are paid, you might say that it does not cost the company anything. But to say that is wrong, because it violates the principle of every risk having an appropriate rate of return. Even though the company might never pay a dividend to a shareholder, that shareholder still requires a rate of return, which is k-e. Never fall into the trap of thinking that equity costs less than debt because it does not pay anything to its shareholders.
One more aspect of cost of equity must be clarified. Do retained earnings (accumulated profits) have a cost, or are they free? Their cost is similar to cost of equity. The company must justify reinvesting profit in the business by earning a sufficient rate of return for shareholders, k-e. Retained earnings has a cost just as every other source of financing has a cost.
The Lease vs. Borrow-to-Buy Decision
Leasing is a form of financing which serves as a substitute for borrowing money to purchase fixed assets such as buildings, production equipment, motor vehicles, office equipment, and tools. Once you decide that the acquisition of a fixed asset is justified by its payback period, net present value or internal rate of return, i.e., the investment decision in Chapter 5, you have completed only the first step. The second step is to decide whether to lease it or to buy it with borrowed money, i.e., the financing decision.
Normally, the after tax cost of debt, k d , is used to discount the cash flows in a lease/buy analysis. Since the cash flows are determined by a lease contract or a loan agreement, they are not subject to much variation, and should be discounted without any risk adjustment related to the higher cost of equity. The analyst might decide to use a different rate for discounting the residual value at the end of the time horizon, because these amounts are not determined by contract and depend on market conditions in the future.
In a capital budgeting (investment) decision, only the cash flows for purchasing the asset and operating the asset were considered, as discussed in Chapter 5. Cash flows for financing cost and repayment of loan principal are never included in an investment decision. But, because the lease/buy decision is a financing decision rather than an investment decision, cash flows for financing cost and repayment of loan principal are the important numbers in the analysis. The operating cash flows for an asset are the same no matter whether the asset is leased or bought, so they have no impact on the lease/buy decision and are disregarded in the analysis.
Purpose of the analysis
The purpose of the lease/buy decision is to select the alternative with the lowest after tax cash outflow. The use you receive from the asset will be the same, whether it is leased or bought. The analysis shows you which method of acquisition is least expensive; the lower the present value of the net cash outflow, the better.
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Layout of the analysis
Use the LEASE VS. BORROW-TO-BUY template in the table below for this analysis. Universal Industries, Ltd. is ready to purchase a new machine at a net price of 10,000 euro. The machine has already been approved using the capital budgeting process discussed in Chapter 5. The vendor of the machine is ready to sell it or lease it, either way. If Universal Industries buys the machine, it will borrow the funds from a commercial bank for a 5-year term at an interest rate of 9%. Alternatively, a leasing agent is vigorously suggesting that Universal Industries can conserve its cash and borrowing capacity by leasing the machine rather than buying it, at an annual lease fee of 2,500 euro for 5 years. At the end of the 5 years, the machine becomes the property of the leasing company. Universal Industries estimates the residual value of the machine at the end of 5 years to be 2,000 euro. Whether Universal Industries leases or buys the machine, the operating expenses are exactly the same; the only differences are the financing costs - lease or buy.
Input data: 1. Enter the cost of the equipment, economic life, annual straight-line depreciation, annual lease payment, and residual value in rows 4-8. 2. Enter the income tax rate in row 9. 3. Enter the interest rate on the loan, 9%, in row 10. 4. Enter the loan amount on row 11.
Analysis of loan: 5. The amount of the loan is netted against the price of the equipment, allowing for a down payment, in C21, which does not occur in this example. 6. The loan is interest-only; the principal is repaid at the end of the loan period. The tax shield on the interest expense in row 17 is calculated by multiplying the tax rate times interest expense. Each euro of interest expense saves 0.156 euro in taxes. 7. Interest expense is a cash outlay. The tax shield on row 19 is a cash inflow because the income tax bill is reduced because of this transaction. 8. The depreciation tax shield is calculated by multiplying the tax rate by depreciation expense, shown as a cash inflow on row 20. Notice that no depreciation expense is deducted in the analysis because it is a not a cash flow. Only the tax shield on the depreciation expense is a cash flow. 9. Row 21 sums the net after tax cash flows. 10. Row 22 gives the present value of the Net After Tax Cash Flow (NATCF) using a discount rate of 7.6%, which is the after-tax interest rate .09 * (1-.156). 11. To make the lease flows and the loan flows comparable, you terminate both of them at the end of the 5 th year. You assume exactly five years of service from the machine under either alternative. The lease flows terminate at the end of the lease period, and the leasing agent keeps the machine. For the loan, you enter a terminal inflow for the value of the machine at the end of the 5 th year, estimated to be 2,000 euro, assuming that you can sell it for that amount at that time. If the sale causes a taxable gain, the residual value is reduced by the amount of the gain.
123 Lease vs. Borrow-to-Buy Template
Analysis of lease: 12. Row 32 calculates the tax shield on the lease payment. The tax shield is the amount of income tax not paid because the lease payment is a tax deductible business expense. It is calculated by multiplying the tax rate by the lease payment. 13. Row 33 gives the NATCF for the lease. Then, the present value of the NATCF is calculated in C34.
The lowest present value is the best deal, because it represents the smallest cash outlay to get the use of the equipment. Both present values are negative because the analysis is based on cash outlays to service the loan and the lease. The lease has a PV of (6,873) euro, cell C34, and the buy has a PV of (6,489) euro, cell C22, making the lease alternative more expensive by 384 euro. However, the decision may rest on the present value of the 2,000 euro residual flow in year 5, which is not a contractual flow as are the lease 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 A B C D E F G H LEASE vs. BORROW-TO-BUY ANALYSIS INPUT DATA COST OF EQUIPMENT 10,000 ECONOMIC LIFE 5 S-L DEPREC 2,000 LEASE PAYMENT 2,500 RESIDUAL 2,000 TAX RATE 35.0% INTEREST RATE 9.0% LOAN AMOUNT 10,000
124 payments and loan payments. Therefore, the 7.6% discount rate, while it is appropriate for the contractual flows that are unlikely to vary up or down, the residual flow may easily be higher or lower than 2,000 euro. To take this variability into account, the analysis discounts the residual flow at various discount rates, shown in cells B25.E27. As the discount rate rises, the PV of the residual falls, from 1,361 to 804. At all discount rates from 8% and 12%, the buy alternative is cheaper, although the advantage shrinks as the discount rate on the residual rises, as shown in the summary figures on row 40, where the advantage to the lease is always a negative number.
The decision about leasing or borrowing rests on whether the residual value is best owned by Universal Industries or the leasing agent. Because the external financing decision was leaning in the direction of equity financing, even under the adverse circumstances of an undervalued share price, financial managers decided to lease the equipment and forego any gain on the residual value five years down the road.
Leasing and Debt Capacity
The vendor of the machine told Universal Industries that leasing would conserve its cash and borrowing capacity, as stated above. Unfortunately, that statement is not valid. You already know from the balance sheet format used in this book, that leases are listed as liabilities just the same as loans. See rows 69 and 76 on the LONG-FORM FORECAST MODEL (LFFM) to refresh your memory. Therefore, leasing and borrowing should be considered as close equivalents. The full burden coverage ratio in Chapter 2, on row 107 of the LFFM template, includes lease expense as well as interest expense in calculating the coverage ratio. To do anything else would be understating the fixed financial costs of the business. A lease is a financial cost in much the same way that interest on a loan is a financial cost.
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