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  1. 1. Finance 640 Financial Management and Policy Lecture Notes Session 6 Introduction Up to this point in the class we have progressed through several important steps in corporate financial analysis. We began with an understanding of financial statements and methods of evaluating standing and performance with the use of financial ratios. We then learned how to forecast financial performance using financial statements and ratios to develop an understanding of how companies might perform in the future. Next, we turned our attention to present value and methods of pricing stocks and bonds. Stocks and bonds are the means by which companies raise money, as well as the market’s way of assigning value to a company once it begins its operations. In our last unit, we examined how those stock and bond pricing models can be used to determine the cost of capital for a company. The cost of capital is an important measure because it represents the return required by investors prior to their allowing a company to use their money. It becomes the cost of using that money to the corporation. In this unit, we begin to put these concepts together to determine the market value of a corporation. The process will begin with financial statements and end with a net present valuation using the weighted average cost of capital (WACC) as a discount factor. Theory of Valuation The main source of value of a corporation is the income it can provide its investors. One way in which we have measured income is using the net income on the income statement. While this is a great measure of the economic performance of a company, it is not necessarily a good measure for determining value to investors. The reason is that net income does not necessarily translate into available cash flow for investors. Investors in a corporation include bondholders and other creditors (such as banks), and both preferred and common equity owners. Creditors are not paid out of the net income of the company, but rather, out of the free operating cash flows generated by the company in the pursuit of its business. A free cash flow is an amount of dollars that are available for distribution to investors. This distribution can take the form of interest and/or principle payments to creditors, dividends paid to shareholders, or funds used to repurchase shares from stockholders. A firm may not have a positive net income, but may have positive free cash flow. Likewise, it may have positive net income, but a negative free cash flow. You will see why as you read on. In finance, value is generally determined by discounting net cash flows. In the case of determining corporate value, we first identify the free cash flows and then we
  2. 2. discount them using an appropriate cost of capital. If we are trying to value the firm as a whole (as opposed to valuing the debt or equity separately), we will use the WACC as the discount factor. More will be said about the implicit assumptions and limitations of this use later on. Free Cash Flows Free cash flows represent cash available for investors after all of the needs of operating the business including its ability to operate in the future are met. The starting point for calculating free cash flow is the net operating income after tax (the book uses the term NOPAT, or net operating profit after tax—generally speaking, income and profit are the same). The net operating income typically includes all revenues and expenses that relate to the day-to-day operation of the business. It does not include interest expenses or any other financial cash flow. It is important to note that the differentiation here is between operating and financial cash flows. Operating revenues are earned and operating expenses incurred as a direct result of applying corporate resources to do business. Financial cash flows, on the other hand, relate to decisions the company has made regarding how it raises its capital. For example, interest and principle payments are financial cash flows. These need to be paid out of the operating cash flows. The company’s ability to make these payments is an important factor in determining its value. Since the payments are made out of the free cash flows, the amounts are not deducted from the free cash flows in determining value. In addition to the NOIAT, there are two other elements to the calculation of the free cash flow. First is the new investment in net working capital required to sustain business operations. As you know, net working capital is the difference between current assets and current liabilities. When measuring current liabilities, however, it is important to include only those that result from day-to-day operations. This would not include any interest bearing liabilities such as notes payable. Notes payable relate to financial and not operating cash flows. The impact of these will be picked up in the WACC. The new investment in net working capital is measured by the change in the level of net working capital required to sustain operations from year-to-year. For example, if the current year’s net working capital level is $469MM, and next year’s required level is $522MM, the new investment in net working capital is the difference between the two, or $53MM. The second element included in the determination of free cash flow is the net investment in plant, property and equipment (fixed assets) needed to sustain the business operation. This amount includes the increase (or decrease) in gross fixed assets (that is, before accumulated depreciation) less the depreciation expense for that year. Subtracting the depreciation expense is the same as adding it back to the free cash flow. This is important because depreciation is a non-cash flow expense that is deducted from the net operating income before taxes are calculated. Since it is available cash, however, it should be included in the free cash flow calculation.
  3. 3. In order to determine the free cash flow for a year, it is necessary to have the income statement for the year and the balance sheets from both the beginning and end of the year. The first step is to identify the net operating income after tax (NOIAT or NOPAT) and then adjust for operating net working capital and net new fixed investments. An example is included in a spreadsheet named freecashflow.xls. From the example you can see several important points. First, dividend payments are not included in the calculation. Dividend payments are residual financial cash flows and are not part of the operating free cash flow. Next, note that the notes payable are not included in the calculation for the same reason. The example shows an operating free cash flow made up of the following: Free Cash Flow Calculation for 2003E 2002 2003E EBIT $9,471 Taxes at 40% ($3,788) NOIAT (NOPAT) $5,683 Change in Operating Net Working Capital Operating Current Assets (Total Current) $5,610 $6,292 Change in Operating Current Assets (2003E-2002) $682 Operating Current Liabilities (A/P and accruals) $2,652 $3,105 Change in Operating Current Liabilities (2003E-2002) $453 Increase (decrease) in Operating Net Working Capital $229 Change in Fixed Assets Gross Fixed Assets $13,200 $15,700 Change in Gross Fixed Assets (2003E-2002) $2,500 Less depreciation expense (2003E) ($1,320) Net new investment $1,180 Free Cash Flow for 2003E NOIAT (NOPAT) $5,683 (Increase) decrease in Operating Net Working Capital ($229) (Increase) decrease in Net new investment ($1,180) Operating Free Cash Flow $4,273 Discounting to Determine Value As mentioned earlier, determining value involves discounting a string of net cash flows. In this application, the net cash flows are the operating free cash flows as measured above. To complete the process of cash flow estimation, we would generate a set of pro forma financial statement forecasts forward for about five to ten years. The calculation of operating free cash flows would be replicated for each of those five to ten
  4. 4. years as above. Once this step has been completed, it is necessary to estimate the value of any cash flow earned by the company beyond the end of the five to ten year forecast period. The present value of these cash flows constitutes what is referred to as the horizon or continuation value of the company. Calculating this value is important because we assume that a company is a going concern with a theoretically unlimited life as an entity. To determine this horizon value, we can take advantage of the “constant growth” stock valuation model we learned in Session 4. Suppose we have a five-year financial forecast, and that the operating cash flow for the fifth year is $5,398MM. To calculate the horizon value we first need to make an assumption about the rate of growth in the cash flows beyond year five. Here, it is always safe to be conservative, so we will use four percent (4%). Assuming that we know the discount factor (as will be seen, it is the WACC) is 12.83%, the horizon value would be calculated as follows: HV5 = OFCF5(1+g)/(WACC – g) = $5,398(1.04)/(.1283-.04) = $5,614/(.0883) = $63,546MM. The $63,546 will become a net cash flow measured at the end of period five. Imagine it as the price at which the firm will sell at that time. If you were investing in the firm today, the $63,546MM would be the value you’d expect to receive when you sell the company in five years. Regardless of whether the company is sold, however, it is still worth that much at the time. The Discount Factor The discount factor used to discount the operating free cash flows is the weighted- average cost of capital. As you learned in Session 5, the WACC accounts for the different types of debt and equity in the capital structure of the company. The weights are determined by the amount of capital raised by each unit. These amounts are usually obtained from the balance sheet, and therefore represent historical book values. The freecashflow.xls spreadsheet has a sample calculation of the WACC, assuming that you already know the values of the individual component costs of capital (e.g. such as the cost of equity that results from the CAPM). The component costs here are assumed (made up), so don’t worry about where they came from. The amounts come from the 2002 balance sheet. Weighted Average Cost of Capital Calculation Type of Capital Amount Weight Component Tax (2)*(3)*(4) Cost Adjustment Note Payable $950 6.40% 9.20% 0.60 0.35% Long Term Debt $1,200 8.09% 10.50% 0.60 0.51% Common Equity $12,688 85.51% 14.00% 1.00 11.97% Total Capital $14,838 100.00% WACC= 12.83%
  5. 5. There are two critical assumptions we implicitly make by using the WACC as a discount factor. First, we assume that the component costs of capital are going to be the same over the entire forecast horizon (which is infinite in this case!). Second, We assume that the relative weights of each source of capital (note payable, long-term debt and common equity) will remain the same over the forecast horizon. While these are somewhat restrictive, we will make do for now and show what happens when things are allowed to change at a later time. Discounting to Determine Value Once we have completed the calculation of the operating free cash flows for the forecast period (in this case, five years), the horizon value, and the WACC, we are ready to measure market value. To do this we simply discount the net cash flows as follows: Corporate Valuation Using Free Cash Flows and WACC Year 2002 2003E 2004E 2005E 2006E 2007E Operating Free Cash Flow $4,273 $4,658 $4,987 $5,123 $5,398 Horizon Value $63,546 Total Free Cash Flow $4,273 $4,658 $4,987 $5,123 $68,944 WACC 12.83% Present (Market) Value @ WACC $51,774 Book Value of Note Payable $950 Book Value of Long Term Debt $1,200 Book Value of Common Stock $12,688 Total Book Value of Capital $14,838 Market Value Added (Market - Book) $36,936 Note that the horizon value is included as a cash flow to be discounted in year five (2007E). The present value of the total free cash flows discounted at 12.83% is $51,774MM as of 2002. This is the market value of the company (this can also be referred to as the market value of the assets, as this company has no non-operating assets). The market value added by managing the assets is $36,936. It is obtained by subtracting the book value of the capital from the market value of the assets, as can be seen above. What you should do now is go through the textbook reading for this session (Chapter 12) and reconcile what you find there to the material in this presentation. A discussion problem will be posted to give you practice in making this calculation.