Capital Part 1

1. Capital
Part 1

2. Topics
• Part 1
o Capital
o Invested capital
o Return to capital
o Profitability ratios
• Part 2
o Cash flow to capital: Free cash flow
o Capital structure
o Cost of capital
o Economic profit
2
V=
FCFi
(1+k)i
i=1
N
å
V is the value of capital or net operating asserts
FCF is cash flow to capital
k is the annual rate cost of capital
N is number of years

3. Balance Sheet Overview
3
Liabilities
Non-interest bearing
Debt
Equity
Assets
Cash
Other
Capital

4. 4
Cash Flows in a Company
Assets
Revenue generating
economic resources
‘Invest’ capital in assets
Capital
Debt
Equity
Raise capital
Return capital
Return to retained earnings
Operating
income
EBIT
Interest
expense to
banks and
bondholders
IX
Income tax
expense
ITX
Dividends to
shareholders
DIV
4

5. 5
Balance Sheet

6. Balance Sheet
6

7. Balance Sheet Notation
Accounting periods span time Dt
Dt = ti – ti-1
An account X has value Xi at
time ti and value Xi-1 at time ti-1
The change in account value
over Dt is DX, DX = Xi - Xi-1
7
i-1 i i+1
ti-1 Dt ti ti+1
Xi-1 DX Xi
Xi+1

8. 8
Balance Sheet

9. Property, Plant, & Equipment
GFAi PPE or gross fixed assets (total cost) at time ti
CX capital expense (“capex”) over ∆t
CG gross cost of PPE sold off over ∆t
GFAi = GFAi-1 + CX – CG
DGFA = CX - CG ti-1
GFAi-1
ti
GFAi
Dt
CX
CG
9

10. Property, Plant, & Equipment
ADi accumulated depreciation on PPE at time ti
DX depreciation expense over ∆t
CC book value (carry cost) of PPE sold off over ∆t
CG gross cost of PPE sold off over ∆t
ADi = ADi-1 + DX – (CG – CC)
CG – CC: Gross cost – carry cost of PPE sold off over Dt
Accumulated depreciation of PPE sold off over Dt
DAD = DX – CG + CC
Accounting income on
the sale of PPE over Dt is
DG = CS – CC
CS is cash received on sale of PPE
10
ti-1
ADi-1
ti
ADi
Dt
DX
CG-CC

11. Property, Plant, & Equipment
GFAi gross fixed asset (total cost) capital investment at time ti
ADi accumulated depreciation on PPE at time ti
NFAi Net fixed assets (PPE) at time ti
NFAi = GFAi - ADi
∆NFA = DGFA – DAD
= (CX – CG) – (DX – CG + CC)
= CX – DX - CC
11
ti-1
NFAi-1
ti
NFAi
Dt
CX -DX -CC

12. Invested Capital
Net Working Capital
NWC = CA – CL
= CE + AR + INV – AP – ITP – SD
Net Operating Working Capital
NOWC = OCE + AR + INV – AP – ITP
DNOWC = DOCE + DAR + DINV – DAP –DITP
Invested Capital (in operations)
IC = NFA + NOWC
∆IC = ∆NFA + ∆NOWC
= CX – DX – CC + ∆NOWC
Also called net operating assets
12

13. Fairway Corp Balance Sheet
13

14. Invested Capital
∆IC = ∆NFA + ∆NOWC
= CX – DX – CC + ∆NOWC
If only fully depreciated assets are sold during the period, then
CC= 0, thus
∆IC = CX – DX + ∆NOWC
For a steady state operating approximation, CX = DX and
∆NOWC = 0, thus
∆IC = 0
14

15. Balance Sheet For Fairway
Corp
15

16. Balance Sheet For Simple
Corp Operations
16
Net Operating
Assets
Invested
Capital
Capital

17. Income Statement
17
*DG=CS-CC=$20,000-$0

18. Return on Invested Capital
Profit, NP, is return to equity (to retained earnings)
NP = (EBIT-IX)·(1 – t) = EBIT·(1 – t) - IX·(1 – t)
Adjust NP to return to capital, NOPAT
o Effective interest, IX∙(1-t), was subtracted out of NP, so add back
o Non-operating effective income such as interest and dividends
received, IDI∙(1-t), was added in, so subtract it back out
o Deferred taxes, DT, had been subtracted out with ITX, so add it back since
it accrues to capital
NOPAT = EBIT·(1 – t) – IX·(1 – t) + IX∙(1-t) - IDI∙(1-t) +DT
= (EBIT– IDI) ·(1 – t) +DT
NOPAT is Net Operating Profit After Tax
18

19. Return on Invested Capital
NOPAT = (EBIT– IDI) ·(1 – t) + DT
If no deferred tax increment, DT =0, and no investment income
from non-operating assets, IDI = 0
Then
NOPAT= EBIT· (1 – t)
19

20. Income Taxes
20
Income taxed paid out (ITC)
Income taxes payable (DITP)
Income taxes deferred (DT)
Income tax expense (ITX)

21. Homework 16A
• Determine the following quantities for Fairway Corp
• Notes:
o During 2015 Fairway Corp sold off some fully depreciated property, plant and
equipment for $20K that originally cost $150K.
o Fairway Corp’s only non-operating assets are its investment securities
21
2014-2015 2015
CX NWC
DG NOWC
DNFA NFA
DNOWC IC
DIC DB (debt)
ITC
NOPAT
ITC = ITX – DT – DITP
= 103 – 5 - 1
= 97
NOPAT = (EBIT– IDI) ·(1 – t) + DT
= 370*(1-.34) + 5
= 249.22
∆IC = CX – DX + ∆NOWC
= 500 – 120 + 173
= 553
500
20
380
173
552
97
249.22
1132
1258
1380
2638
961

22. Profitability Ratios
• Profit margin (rate)
o a measure of revenue productivity
o how much net profit, NP, is generated from $1 of revenue, R?
NP
R
=
200
3190
= .0627
22

23. Profitability Ratios
• Return (rate) on assets, roa
o a measure of asset productivity
o how much net profit, NP, is generated from $1 of
total assets, TA?
roa =
NP
TA
=
200
2876
= .0695
23

24. Profitability Ratios
• Return (rate) on equity, roe
o a measure of equity productivity
o how much net profit, NP, is generated from $1 of total book equity,
EB?
24
roe =
NP
EB
=
200
1823
= .1097

25. Profitability Ratios
The DuPont formula defines roe as a product of three
ratios to provide insight into 3 aspects of the firm
: net profit margin - How much net profit is produced per $1 of
revenue?
: asset productivity relative to revenue - How much revenue is
produced per $1 of total assets?
: measure of financial leverage - What is the dollar value of firm
assets per $1 of equity?
roe =
NP
EB
=
NP
R
×
R
TA
×
TA
EB
NP
R
R
TA
TA
EB
25

26. Profitability Ratios
net profit margin - How much net
profit is produced per $1 of
revenue?
asset productivity relative to
revenue - How much revenue is
produced per $1 of total assets?
measure of financial leverage -
What is the value of firm assets per
$1 of equity?
For operating and non-operating
Fairway Corp assets, revenue, and
equity
26
roe =
NP
R
×
R
TA
×
TA
EB
=
200
3190
×
3190
2876
×
2876
1823
= .0627×1.109×1.578
= .1097

27. Profitability Ratios
• Return (rate) on invested capital, roic
o a measure of revenue productivity
o how much net profit, NP, is generated from $1 of revenue, R?
roic=
NOPAT
IC
=
NOPAT
NOWC+NFA
=
249.22
1258+1380
= .0945
27

28. Financial Decisions at
Simple Corp
28
roic > k

29. Homework 16B
• Determine the roic for Fairway Corp
o Show calculations
29

30. Ratios
• Balance sheet denominators might be also be defined as
averages
• Example roe
30
roe =
NP
EB2014
=
200
1823
= .1097
roe =
NP
1
2
EB2015 +EB2014( )
=
200
1
2
1823+2007( )
=.1044

31. Homework 16C
• Determine the following quantities for Fairway Corp
o Use the average balance sheet quantities in the denominator
• roa
• roic
• roe with DuPont formula
31

32. Interest Coverage Ratios
32
icr =
EBIT
IX
=
370
67
= 7.57

33. Interest Coverage Ratios
33
Greater
than
To Rating
12.5 100000 AAA
9.5 12.499999 AA
7.5 9.499999 A+
6 7.499999 A
4.5 5.999999 A-
4 4.499999 BBB
3.5 3.9999999 BB+
3 3.499999 BB
2.5 2.999999 B+
2 2.499999 B
1.5 1.999999 B-
1.25 1.499999 CCC
0.8 1.249999 CC
0.5 0.799999 C
0.499999 D
For smaller non-
financial service
companies with
market cap < $ 5
billion
From A. Damodaren’s website