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Chapter 02 Financial Statements

Determinants of Intrinsic Value: Calculating FCF


Sales revenues Operating costs and taxes Required investments in operating capital =

Free cash flow (FCF)

Value =

FCF1 FCF2 FCF ... + + + (1 + WACC)1 (1 + WACC)2 (1 + WACC)

Weighted average cost of capital (WACC)

Market interest rates


Market risk aversion

Cost of debt Cost of equity

Firms debt/equity mix


Firms business risk
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Financial Statements

Balance Sheet

Financial Management - Reza Masri

Balance Sheet

Financial Management - Reza Masri

Balance Sheet
The basic principles to read Balance Sheet are:

LIQUIDITY: Promptness with which assets are expected time


to be converted into cash

REPAYING PERIOD: Time within which obligations are


expected to be satisfied

Financial Management - Reza Masri

Balance Sheet

Financial Management - Reza Masri

Balance Sheet

Financial Management - Reza Masri

Balance Sheet

Financial Management - Reza Masri

Balance Sheet

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

MicroDrive Inc. December 31 Balance Sheets (in millions of dollars) 2010 2009 Assets Cash and equivalents $10 $15 Short-term investments $0 $65 Accounts receivable $375 $315 Inventories $615 $415 Total current assets $1.000 $810 Net plant and equipment $1.000 $870

2010 Liabilities and equity Accounts payable Notes payable Accruals Total current liabilities Long-term bonds Total debt Preferred stock (400,000 shares) Common stock (50,000,000 shares) Retained earnings Total common equity Total liabilities and equity $60 $110 $140 $310 $754 $1.064 $40 $130 $766 $896 $2.000

2009 $30 $60 $130 $220 $580 $800 $40 $130 $710 $840 $1.680

Total assets

$2.000

$1.680

Asset: things that company owns, listed in liquidity order


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Liabilities & Equity: claims against companys value, listed in the maturity order

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Income Statement

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Income Statement

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Income Statement

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Income Statement
A basic principle to read Income Statement:

DEDUCTING PRINCIPLE

To deduct progressively costs from revenues following the production- sales cycle Goals: To show different margins

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Income Statement

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Income Statement

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Income Statement

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Income Statement

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Income Statement

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Income Statement
Reflects financial performance during a period
MicroDrive Income Statements for Years Ending December 31 (in millions of dollars) 2010 INCOME STATEMENT Net sales Operating costs except depreciation Earnings before interest, taxes, deprn, and amortization (EBITDA)* Depreciation Earnings before interest and taxes (EBIT) Less interest Earnings before taxes (EBT) Taxes Net Income before preferred dividends Preferred dividends Net Income available to common stockholders Common dividends Addition to retained earnings *MicroDrive has no amortization charges. 2009

$3.000,0 $2.850,0 $2.616,2 $2.497,0 $383,8 $353,0 $100,0 $90,0 $283,8 $263,0 $88,0 $60,0 $195,8 $203,0 $78,3 $81,2 $117,5 $121,8 $4,0 $4,0 $113,5 $117,8 $57,5 $56,0 $53,0 $64,8

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Statement of Retained Earnings


MicroDrive Statement of Retained Earnings (in millions of dollars) Balance of Retained Earnings, Dec. 31, 2009 Add: Net Income, 2010 Less: Dividends to common stockholders Balance of Retained Earnings, Dec. 31, 2010 $710,0 $113,5 -$57,5 $766,0

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Statement of Cash Flows

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Statement of Cash Flows


Net Cash Flow = Net Income Noncash Revenues + Noncash Charges
MicroDrive Statement of Cash Flows for Years Ending Dec. 31 (in millions of dollars) Operating Activities Net Income before preferred dividends Noncash adjustments Depreciation and amortization Due to changes in working capital Increase in accounts receivable Increase in inventories Increase in accounts payable Increase in accruals Net cash provided by operating activities Long-term investing activities Cash used to acquire fixed assets Financing Activities Sale of short-term investments Increase in notes payable Increase in bonds Payment of common and preferred dividends Net cash provided by financing activities Net change in cash and equivilents Cash and securities at beginning of the year Cash and securities at end of the year
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$117,5 $100,0 ($60,0) ($200,0) $30,0 $10,0 ($2,5)

($230,0)

$65,0 $50,0 $174,0 ($61,5) $227,5 ($5,0) $15,0 $10,0


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What are the five uses of FCF?


1. Pay interest on debt. 2. Pay back principal on debt. 3. Pay dividends. 4. Buy back stock. 5. Buy nonoperating assets (e.g., marketable securities, investments in other companies, etc.)

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Determining Free Cash Flow (FCF)


Operating Cash Flow Investment in Operating Capital NOPAT (Net Operating Profit After Taxes)

Amount of profit a company would generate if it had no debt and held no financial assets Take out impacts of financing & investing decisions to have pure measure of operating performance

NOPAT = EBIT(1-Tax Rate)

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Free Cash Flows (FCF)

Cash flows can not be maintained over time unless depreciated fixed assets are replaced, so management is not completely free to use net cash flows. Free Cash Flows is the cash flow actually available for distribution to investors after the company has made all the investments in fixed assets and working capital necessary to sustain ongoing operation

NOPAT = EBIT(1-Tax Rate) FCF = NOPAT Net investment in operating capital Gross Investment = Net Investment + Depreciation FCF = (NOPAT + Depreciation) Gross Investment in operating capital
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Operating Capital
Total net operating capital = Net operating working capital + Operating long term assets

Net operating working capital = Operating current asset Operating current liabilities Net operating working capital = (Cash + Accounts Receivable + Inventories) - (Accounts Payable + Accruals)

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Free Cash Flows (FCF)


- MicroDrive Illustration
EBIT (1-Tax Rate) NOPAT 283,8 0,6 170,28 2010 Cash Accounts Receivable Investories Operating Current Assets minus Accounts Payable Accruals Operating Current Liabilities Net Operating Working Capital plus Operating Long Term Assets Total Net Operating Capital Net Investment in Opr Capital NOPAT Net Investment 170,28 345 (-) 10 375 615 1.000 60 140 200 800 1.000 1.800 345 2009 15 315 415 745 30 130 160 585 870 1.455

FCF

(175)
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Return on Invested Capital


ROIC = NOPAT Operating Capital

MicroDrive Illustration

ROIC =

170.3 0.0946 1,800

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Market Value Added (MVA)

To incorporate stock prices in the analysis as the primary goal of management is to maximize the firms value, hence the outstanding shares times stock price Measures the effects of managerial actions since the inception of the company

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

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Economic Value Added (EVA)

Focuses on managerial effectiveness in a given year

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

EVA = (Operating capital)(ROIC WACC)

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MVA & EVA - Illustration


2010 MVA = = = 2010 2009 MVA = MVA = = = 2009 MVA = Stock price $23,00 $254 Stock price $26,00 $460 x x $1.300 # of shares 50 Total common equity $840 $840 x x $1.150 # of shares 50 Total common equity $896 $896

2010

EVA

2010 2009

EVA EVA

= = = = = = = =

NOPAT $170,3 $170,3 -$27,7 NOPAT $157,8 $157,8 $0,7

Operating Capital x $1.800 x $198,0

Weighted average cost of capital 11%

Operating Capital x $1.455 x $157,1

Weighted average cost of capital 11%

2009

EVA

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