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Capital and return on capital pdf
- 1. Capital and Return on Capital
- 2. Learning Objec-ves 2 ¨ Understand key finance concepts based on the balance sheet and income statement ¤ ¤ ¤ ¨ ¨ Understand opera-ng and financing contribu-ons to return Understand basic financial decision making criterion ¤ ¨ Capital and Invested Capital Return to and rate of return on invested capital Rate cost of invested capital Rate of return on invested capital must be greater than the rate cost of invested capital Understand accoun-ng informa-on in algebraic form for financial calcula-ons
- 3. Financial Statements 3 ¨ Balance Sheet ¤ Presents an organiza-on’s financial status via historical and adjusted costs ¨ Income Statement ¤ Presents financial flows on an accrual basis n ¨ Matches revenue and cost / expense Statement of Cash Flows ¤ Presents financial flows on a cash basis
- 4. Asset Account Adjustments 4 ¨ Asset account adjustments ¤ Marked to fair or market value n ¤ ¤ ¤ ¤ ¨ e.g., inventory, accounts receivable, financial assets for trading or available for sale Depreciated e.g., plant and equipment Depleted e.g., natural resources Amor-zed e.g., intangible assets under some condi-ons Marked down due to impairment e.g., goodwill AOer adjustments, do the balance sheet total assets represent the fair value of the firm? ¤ Fair value is n n the present value of the expected future cash flows and The fair value of the firm’s capital
- 5. Balance Sheet 5 FAIRWAY CORPORATION Balance Sheet As of December 31, 2010, and 2011 (in thousands) Assets 2010 2011 Current assets: Cash and cash equivalents……………………………………………. $ 230 $ 326 Accounts receivable………………………...…………………………………. $ 586 $ 673 Inventories……………………...………………………………………………….. $ 657 $ 610 Total current assets…………………………………………………. $ 1,426 $ 1,656 Long-‐term assets: Property, plant, and equipment, at cost……………………………………. $ 2,350 $ 2,000 Accumulated depreciation……………………….……………………………….. $ (970) $ (1,000) Property, plant, and equipment, net……………………………………………… $ 1,000 $ 1,380 Investment s ecurities…………………………………………..………………….. $ 400 $ 450 Total noncurrent assets…………………………………………… $ 1,450 $ 1,780 Total assets……………………………………..………………………………………………..$ 3,436 $ 2,876 Change $ 96 $ 87 $ 47 $ 230 $ 350 $ 30 $ 380 $ (50) $ 330 $ 560 Liabilities and Shareholders' Equity Current liabilities: Accounts payable…………………………….……………………………………. $ 388 $ 332 Income taxes payable………………………….…………………………………….$ 10 $ 9 $ 56 $ 1 Short-‐term debt……………………………...….……………………………………. $ 126 $ 147 $ (21) Total current liabilities……………………………………………….. $ 488 $ 524 $ 36 Long-‐term debt…………………………...…………………………………………………….$ 835 $ 500 $ 335 Deferred taxes……………………………………………………………………….. $ 65 $ 70 $ 5 $ 1,429 $ 376 Shareholders' equity: Common s tock ($1 par) …………………………………………...……………. $ 60 $ 50 Additional paid-‐in capital…………….……………………………………. $ 133 $ 167 Retained earnings…………………………………..……………………………… $ 1,780 $ 1,640 Total s hareholders' equity…………………………..……………….. $ 2,007 $ 1,823 Total liabilities and s hareholders' equity………………………………….……….. 3,436 $ 2,876 $ $ 10 $ 34 $ 140 $ 184 $ 560 Total liabilities……………………………...…………………………….. $ 1,053
- 6. Balance Sheet Assets 6 FAIRWAY CORPORATION Balance Sheet As of December 31, 2011 (in thousands) 2011 Current assets: Cash and cash equivalents……………………………………………. 326 $ Accounts receivable………………………...…………………………………. $ 673 Inventories……………………...………………………………………………….. $ 657 Total current assets…………………………………………………. ,656 $ 1 Long-‐term assets: Property, plant, and equipment, at cost……………………………………. $ 2,350 Accumulated depreciation……………………….……………………………….. $ (970) Property, plant, and equipment, net……………………………………………… $ 1,380 Investment s ecurities…………………………………………..………………….. $ 400 Total noncurrent assets…………………………………………… $ 1,780 Total assets……………………………………..……………………………………………….. $ 3,436 Liabilities and Shareholders' Equity Current liabilities: Accounts payable…………………………….……………………………………. $ 388 Income taxes payable………………………….……………………………………. $ 10 Short-‐term debt……………………………...….……………………………………. $ 126 Total current liabilities………………………………………………..524 $ Long-‐term debt…………………………...……………………………………………………. $ 835 Assets Liabilties and Shareholders' Equity Current Assets CE $ 326 AR $ 673 INV $ 657 CA $ 1,656 Current Liabilitites AP $ 388 ITP $ 10 SD $ 126 CL $ 524 Long-‐term Assets Long-‐term Liabilities GC AD NC IS LA $ 2,350 $ (970) $ 1,380 $ 400 $ 1,780 LD T LL TA $ 3,436 PAR APC RE EB $ 835 $ 70 $ 905 Shareholders' Equity Deferred taxes……………………………………………………………………….. 70 $ Total liabilities……………………………...…………………………….. $ 1,429 Shareholders' equity: Common s tock ($1 par) …………………………………………...……………. $ 60 Additional paid-‐in capital…………….……………………………………. $ 167 Retained earnings…………………………………..……………………………… $ 1,780 Total s hareholders' equity…………………………..……………….. $ 2,007 Total liabilities and s hareholders' equity………………………………….……….. $ 3,436 LE $ 60 $ 167 $ 1,780 $ 2,007 $ 3,436
- 7. Balance Sheet 7 $3,500 TA = CA + LA CA = CE + AR + INV LA = NC + IS WC = CA – CL CE $3,250 AP ITP CL $3,000 SD AR $2,750 $2,500 CA DB LL LD $2,250 LE = CL + LL + EB $1,500 $1,250 LL = LD + T $1,000 T $1,750 CL = AP + ITP + SD INV $2,000 NC LA $750 EB = PAR + APC + RE PAR APC $500 DB = SD + LD $250 $-‐ IS RE EB
- 8. $3,500 Opera-ng Assets TA TA $3,250 CE NOCE 8 $2,750 Group assets by • Assets necessary to support business opera-ons, OA • Other assets, NOA • TA = OA + NOA At Fairway Corp. • IS are non-‐opera-ng assets • Frac-on, f, of the CE are non-‐ opera-ng cash & equivalents CE = NOCE + OCE NOCE = f·∙CE OCE = (1-‐f)·∙CE IS $3,000 NOA OCE AR CA $2,500 AR $2,250 INV $2,000 OCA INV $1,750 $1,500 $1,250 N NC $1,000 LA NC $750 $500 $250 $0 OA IS
- 9. Finance View of Balance Sheet 9 Assets (TA) Liabili6es and Equity (LE) Opera-ng current assets (OCA) OA NOA Opera-ng current liabili-es (OCL) Opera-ng long-‐term assets (OLA) ‘Non-‐opera-ng’ liabili-es Non-‐opera-ng current assets (NCA) Deferred Tax (T) Non-‐opera-ng long-‐term assets (NLA) TA = OA + NOA = (OCA+OLA) + ( NCA+NLA) OWC ≡ OCA – OCL $ 1,069 OWC $ 3,038 C $ 1,380 OLA $ (589) NOA $ 2,449 IC $ 2,449 IC Debt (DB=SD+LD) Capital (C ) Equity (EB) LE = OCL + DB + T + EB C = DB + EB + T IC = OWC + OLA = OWC + NC = C – NOA IC = OWC + NC ΔIC = ΔOWC + ΔNC
- 10. Finance View of Balance Sheet 10 TA = OA + NOA = (OCA+OLA) + ( NCA+NLA) OWC ≡ OCA – OCL ≡ OCE + AR + INV – AP -‐ ITP LE = OCL + SD + LL + EB = OCL + DB + EB + T ≡ OCL + C C = DB + EB + T IC = C – NOA IC = OWC + OLA IC= OWC + NC OWC: opera-ng working capital C: Capital IC: invested capital or opera-ng capital TA $3,500 LE OCE $3,250 $3,000 OCL AP ITP SD AR $2,750 OCA $2,500 DB INV $2,250 OA LD LL T $2,000 $1,750 $1,500 NC $1,250 EB N $1,000 $750 $500 $250 $0 C OLA NOA NOCE NCA IS NLA
- 11. Invested Capital 11 $3,500 $3,250 $3,000 $2,750 $2,500 OCL T OCL NOA NOA OCL DB $2,250 $2,000 $1,750 IC $1,500 OA IC C EB $1,250 $1,000 $750 $500 $250 $-‐ TA TA = IC + NOA + OCL = C + OCL TA = LE LE Note: Assume NOA funded by capital, C, not OCL
- 12. Working Capital 12 $1,750 $1,500 CE OCE $1,250 WC $1,000 $750 AR AR OWC INV INV $500 AP ITP NWC INV SD $250 AR AP ITP AP ITP $0 WC ≡ CA -‐ CL = AR + INV + CE – AP – ITP –STD Working Capital OWC ≡ OCA -‐ OCL ≡ AR + INV + OCE – AP – ITP Opera-ng Working Capital NWC ≡ AR + INV – AP – ITP Net Working Capital
- 13. Balance Sheet Assets 13 2010 2011 Current assets: Cash and cash equivalents……………………………………………. $ 230 $ 326 Accounts receivable………………………...…………………………………. $ 586 $ 673 Inventories……………………...………………………………………………….. $ 657 $ 610 Total current assets…………………………………………………. $ 1,426 $ 1,656 Long-‐term assets: Property, plant, and equipment, at cost……………………………………. $ 2,350 $ 2,000 Accumulated depreciation……………………….……………………………….. $ (970) $ (1,000) Property, plant, and equipment, net……………………………………………… $ 1,000 $ 1,380 Investment s ecurities…………………………………………..………………….. $ 400 $ 450 Total noncurrent assets…………………………………………… $ 1,450 $ 1,780 Total assets……………………………………..………………………………………………..$ 3,436 $ 2,876 Change $ 96 $ 87 $ 47 $ 230 Assets Liabilties and Shareholders' Equity $ 350 $ 30 $ 380 $ (50) $ 330 $ 560 Current Assets ∆CE $ 96 ∆AR $ 87 ∆INV $ 47 ∆CA $ 230 Current Liabilitites ∆AP $ 56 ∆ITP $ 1 ∆SD $ (21) ∆CL $ 36 Long-‐term Assets Long-‐term Liabilities Liabilities and Shareholders' Equity Current liabilities: Accounts payable…………………………….……………………………………. $ 388 $ 332 Income taxes payable………………………….…………………………………….$ 10 $ 9 $ 56 $ 1 Short-‐term debt……………………………...….……………………………………. $ 126 $ 147 $ (21) Total current liabilities……………………………………………….. $ 488 $ 524 $ 36 Long-‐term debt…………………………...…………………………………………………….$ 835 $ 500 $ 335 Deferred taxes……………………………………………………………………….. $ 65 $ 70 $ 5 $ 1,429 $ 376 Shareholders' equity: Common s tock ($1 par) …………………………………………...……………. $ 60 $ 50 Additional paid-‐in capital…………….……………………………………. $ 133 $ 167 Retained earnings…………………………………..……………………………… $ 1,780 $ 1,640 Total s hareholders' equity…………………………..……………….. $ 2,007 $ 1,823 Total liabilities and s hareholders' equity………………………………….……….. 3,436 $ 2,876 $ $ 10 $ 34 $ 140 $ 184 $ 560 Total liabilities……………………………...…………………………….. $ 1,053 FAIRWAY CORPORATION Balance Sheet Changes For Year Ending December 31, 2011 (in thousands) ∆GC ∆AD ∆NC ∆IS ∆NCA $ 350 $ 30 $ 380 $ (50) $ 330 ∆LD ∆T ∆LL ∆TA $ 560 ∆PAR ∆APC ∆RE ∆EB $ 335 $ 5 $ 340 Shareholders' Equity ∆LE $ 10 $ 34 $ 140 $ 184 $ 560
- 14. Balance Sheet Nota-on 14 Accoun-ng periods span -me Δt Δt = ti – ti-‐1 An account X has value Xi at -me ti and value Xi-‐1 at -me ti-‐1 The change in account value over Δt is ΔX Xi-‐1 ΔX Xi Xi+1 i-‐1 i i+1 ti-‐1 Δt ti ti+1 ΔX = Xi -‐ Xi-‐1 X may be an abbrevia-on for the account type or the value of the account, for example AR is Accounts Receivable or AR = $673,000 Subscripts are omiked for simplicity except when necessary for clarity
- 15. Property, Plant, & Equipment (PPE) 15 ¨ ¨ ¨ ¨ ¨ GCi gross (total) capital investment at -me ti (PPE at cost) CX capital expense (“capex”) over ∆t CG gross cost of PPE sold off over ∆t GCi = GCi-‐1 + CX – CG Δt ti-‐1 CX GCi-‐1 ΔGC = CX -‐ CG CG ti GCi
- 16. Property, Plant, & Equipment (PPE) 16 ¨ ¨ ¨ ¨ ADi DX CC ADi ¤ ¤ ¨ ¨ accumulated deprecia-on on current PPE at -me ti deprecia-on expense over ∆t book value (carry cost) of PPE sold off over ∆t = ADi-‐1 + DX – (CG -‐ CC) (CG -‐ CC): Gross cost – carry cost of PPE sold off over Δt Accumulated deprecia-on of PPE sold off over Δt ΔAD = DX – CG + CC Accoun-ng income on the sale of PPE over Δt is ¤ ¤ DG = CS – CC CS is cash received on sale of PPE ti-‐1 Δt ti ADi-‐1 DX ADi CG-‐CC
- 17. Property, Plant, & Equipment 17 NCi = GCi -‐ ADi (Net PPE) ti-‐1 ¨ ∆NC = ΔGC -‐ ΔAD NCi-‐1 = CX – CG – (DX – CG + CC) = CX – (DX + CC) ¨ ∆IC = ∆NC + ∆OWC = CX – DX – CC + ∆OWC ¨ Δt ti CX NCi DX+CC
- 18. Income Statement 18 FAIRWAY CORPORATION Income Statement and Statement of Retained Earnings For the Year Ended December 31, 2011 (in thousands) FAIRWAY CORPORATION Income Statement and Statement of Retained Earnings For the Year Ended December 31, 2011 (in thousands) Sales revenues…………………………………………………………...……………………. $ 3,190 R…………………………….3,190 $ Cost of s ales…………………………………………...………………………………………. $ 2,290 COGS $ 2,290 Gross margin…………………………………..……………………………………. $ 900 GM………………….. 900 $ Expenses: OX $ 449 Depreciation…………………………………………… 120 $ NX $ (39) Other expenses………………………………………. 477 * $ EBITDA………………………490 $ Income taxes………………………………………….. 103 $ $ 700 DX $ 120 Net Income………………………………………..…………………………………………… $ 200 EBIT…………………. 370 $ IX $ 67 Retained earnings, December 31, 2010…………………………………….………… $ 1,640 IT $ 103 Add: 2007 net income…………………………………...……………………………. NP……………………………. 200 $ 200 $ Less: Cash dividends……………………………………….…………………………….. $ (60) Retained earnings, December 31, 2011……………………………………………….………… $ 1,780 RE2010 $ 1,640 NP $ 200 *Net of $20,000 gain on disposal of equipment DIV $ (60) RE2011 $ 1,780 DG=CS-‐CC=$20,000-‐$0 Revenue Cost of goods s old Gross margin Operating expenses Other expenses (income) Earnings before int, tax, and depre Depreciation expense Earnings before interest and tax Interest expense Income tax expense Net profit Previous retained earnings Net profit Cash dividends Current retained earnings
- 19. Opera-ng Cash Flow: Direct Method 19 FAIRWAY CORPORATION Statement of Cash Flows For the Year Ending December 31, 2011 (in thousands) Cash flows from operating activities: RC Cash received from customers…………………………………………..………………………… $ 3,103 IDI Dividends and interest received……………………………………….……………………………………… $ 19 RC Total cash from operations ………………………………………………….+ IDI $ 3,122 Cash paid to s uppliers and employees ………………………………………………………………………. $ 2,730 COGSC + OX IX Interest paid ……………………………………………………………………………………………… $ 67 ITC Income tax paid ………………………………………………………………………………………… $ 97 Cash disbursed for operating activities ……………………………………………… $ 2,894 CFO Net cash flow from operating activities ……………………………………………………. $ 228 Supplement to support income statement rearrangement
- 20. Income Statement 20 ¨ ¨ ¨ Income statements for different firms show a variety of income and expense categories Reconcile the text and course income statements $ 449.00 OX SG&A, R&D, Operating Expenses Other expenses (income) $ (39.00) NX NX = -‐IDI -‐ DG $ 67.00 IX Interest expense $ 477.00 Other Expenses NX is other expenses and income ¤ IDI = Interest and Dividends Income, $19K Dividends from IS and interest from NOCE n OCE is in a non-‐interest bearing bank account at Fairway n ¤ DG = gain from disposal of equipment, $20K n DG = CS – CC = $20K -‐ $0 = $20K
- 21. Net Profit 21 ¨ ¨ ¨ ¨ ¨ NP: Net profit EBIT: Earnings before interest and taxes IX: Interest expense IT: Income tax expense, τ average income tax rate NP = EBIT – IX – IT ¤ ¨ ¨ IT = τ ·∙(EBIT – IX) = τ ·∙EBIT – τ ·∙ IX NP = EBIT – IX – τ ·∙EBIT +τ ·∙ IX NP = EBIT(1 – τ) – IX(1 – τ) = (EBIT– IX)·∙(1 – τ) τ ·∙ IX =Tax shield, TS Marginal corporate income tax rates by country Avg corporate income tax rates by industry
- 22. Income Tax Expense 22 Cash paid out, ITC Accrues to deferred tax, ΔT (Capital) IT Income tax expense Accrues to income tax payable, ΔITP (NIBCL) IT = ITC + ΔITP + ΔT
- 23. Income From Opera-ons and Finance 23 ¨ Consider two “versions” of Fairway ¤ ¤ One with and one without debt Leveraged and unleveraged Earnings before interest and tax EBIT τ Average income tax rate Income from operations EBIT·∙(1 -‐ τ) Interest expense IX Income tax expense (EBIT-‐IX)·∙τ Tax shield IX·∙τ Effective interest paid IX(1 -‐ τ) Net profit (EBIT-‐IX)(1-‐τ) NP = EBIT(1 – τ) – IX + IX·∙τ Fairway’s average tax rate is actually 33.993% Actual, levered Fairway Hypothetical, unlevered, "all equity" Fairway $ 370.00 34.0% $ 244.22 $ 67.00 $ 103.00 $ 22.78 $ 44.22 $ 200.00 $ 370.00 34.0% $ 244.22 $ -‐ $ 125.78 $ -‐ $ -‐ $ 244.22
- 24. Income From Opera-ons and Finance 24 FAIRWAY CORPORATION Income Statement With Separation of Operations and Finance For the Year Ended December 31, 2011 (in thousands) R COGS GM OX NX EBITDA DX EBIT τ·∙EBIT EBIT·∙(1-‐τ) IX TS IX·∙(1-‐τ) NP $ 3,190.00 $ 2,290.00 $ 900.00 $ 449.00 $ (39.00) $ 490.00 $ 120.00 $ 370.00 $ 125.78 $ 244.22 $ 67.00 $ 22.78 $ 44.22 $ 200.00 Revenue Cost of goods s old Gross margin Operating expenses Other expenses (income) Earnings before interest, tax, and depreciation Depreciation expense Earnings before interest and tax Hypothetical income tax on EBIT Hypothetical after tax income on EBIT Interest expense NP = EBIT – τ ·∙EBIT – IX +τ ·∙ IX Tax s hield (IX·∙τ) Effective interest expense (IX -‐ TS) Net profit
- 25. Income From Opera-ons and Finance FAIRWAY CORPORATION Income Statement and Statement of Retained Earnings For the Year Ended December 31, 2011 (in thousands) 25 R COGS GM OX DG EBITDA DX EBIT τ·∙EBIT EBIT·∙(1-‐τ) IX IX·∙τ IX·∙(1-‐τ) IDI IDI·∙τ IDI·∙(1-‐τ) NP $ 3,190.00 $ 2,290.00 Revenue Cost of goods s old $ 900.00 $ 449.00 $ (20.00) $ 471.00 $ 120.00 $ 351.00 $ 119.32 $ 231.68 Gross margin Operating expenses Loss on s ale of equipment Earnings before interest, tax, and depreciation Depreciation expense Operating income Hypothetical income tax on operating income Hypothetical after tax operating income $ 67.00 $ 22.78 $ 44.22 $ 19.00 $ 6.46 $ 12.54 Interest expense Tax s hield (TS) Effective interest expense Investment (non-‐operating) income Tax on investment income After tax investing income $ 200.00 Net operating profit
- 26. Income Statement Flows 26 ‘Invest’ capital Assets Revenue genera-ng economic resources Opera-ng income EBIT Interest expense to banks and bondholders IX Capital Debt Equity Raise capital Return capital Return to retained earnings RE Dividends to shareholders DIV Income tax expense IT
- 27. Important Ra-os 27 ¨ Return on Assets ¤ roa is a measure of asset produc-vity n ¨ how much net profit, NP, is generated from $1 of total book value of assets, TA? NP roa = TA Return on Equity ¤ roe is a measure of equity produc-vity n n Current Assets CE $ 326 AR $ 673 INV $ 657 CA $ 1,656 how much net profit, NP, is generated from Noncurrent Assets $1 of total book equity, EB? TA $ 2,350 measurement of ‘leverage’ – levers roa to roe GC EB EBIT…………………. 370 $ IX $ 67 IT $ 103 NP……………………………. 200 $ NP NP TA = ⋅ EB TA EB TA = roa ⋅ EB roe = AD NC IS NCA $ (970) $ 1,380 $ 400 $ 1,780 TA $ 3,436
- 28. Important Ra-os 28 ¨ The DuPont formula defines roe as a product of three accoun-ng ra-os to provide insight into 3 aspects of the firm NP NP R TA roe = = ⋅ ⋅ EB R TA EB ¤ ¤ ¤ NP : net profit margin -‐ How much net profit is produced per $1 of R revenue? R : asset produc-vity rela-ve to revenue -‐ How much revenue is produced per $1 of total assets? TA TA : measure of financial leverage -‐ What is the dollar value of firm EB assets per $1 of equity?
- 29. Important Ra-os 29 ¨ ¨ Capital Structure (leverage) DB $961 = = 0.48 EB $2007 TA $3436 = = 1.71 EB $2007 Interest coverage ra-o EBIT $370 IX = $67 = 5.5 Liabilties and Shareholders' Equity R…………………………….3,190 $ COGS $ 2,290 Current Liabilitites $ AP $ 388 GM………………….. 900 ITP $ 10 OX $ 449 STD $ 126 NX $ (39) CL $ 524 EBITDA………………………490 $ DX $ 120 Noncurrent Liabilities EBIT…………………. 370 $ LTD $ 835 IX $ 67 T $ 70 IT $ 103 NCL $ 905 NP……………………………. 200 $ Shareholders' Equity PAR APC RE EB $ 60 $ 167 $ 1,780 $ 2,007 LE $ 3,436 RE2010 NP DIV RE2011 $ 1,640 $ 200 $ (60) $ 1,780
- 30. Bond Ra-ngs From Interest Coverage Ra-o 30 EBIT IX For large manufacturing firms If interest coverage ratio is > ≤ to Rating is -‐100000 0.199999 D 0.2 0.649999 C 0.65 0.799999 CC 0.8 1.249999 CCC 1.25 1.499999 B-‐ 1.5 1.749999 B 1.75 1.999999 B+ 2 2.2499999 BB 2.25 2.49999 BB+ 2.5 2.999999 BBB 3 4.249999 A-‐ 4.25 5.499999 A 5.5 6.499999 A+ 6.5 8.499999 AA 8.50 100000 AAA Ra-ngs are illustra-ve not fixed or theore-cal From Prof. Damodaran’s website at NYU For financial service firms For smaller and riskier firms If long term interest coverage ratio is If interest coverage ratio is > ≤ to Rating is > ≤ to Rating is -‐100000 0.049999 D -‐100000 0.499999 D 0.05 0.099999 C 0.5 0.799999 C 0.1 0.199999 CC 0.8 1.249999 CC 0.2 0.299999 CCC 1.25 1.499999 CCC 0.3 0.399999 B-‐ 1.5 1.999999 B-‐ 0.4 0.499999 B 2 2.499999 B 0.5 0.599999 B+ 2.5 2.999999 B+ 0.6 0.749999 BB 3 3.499999 BB 0.75 0.899999 BB+ 3.5 3.9999999 BB+ 0.9 1.199999 BBB 4 4.499999 BBB 1.2 1.49999 A-‐ 4.5 5.999999 A-‐ 1.5 1.99999 A 6 7.499999 A 2 2.49999 A+ 7.5 9.499999 A+ 2.5 2.99999 AA 9.5 12.499999 AA 3 100000 AAA 12.5 100000 AAA
- 31. Capital Structure Examples 31 Market Number Average D/E Industry N ame of Firms Beta Ratio Advertising 31 2.02 43.3% Aerospace/Defense 64 1.10 25.7% Air Transport 36 1.21 24.3% Apparel 57 1.30 18.4% Auto Parts 51 1.70 27.6% Automotive 12 1.59 134.6% Bank 426 0.77 156.1% Bank (Midwest) 45 0.93 59.5% Beverage 34 0.88 26.5% Biotechnology 158 1.03 13.5% Building Materials 45 1.50 94.3% Cable TV 21 1.37 68.1% Chemical (Basic) 16 1.36 27.3% Chemical (Diversified) 31 1.51 22.4% Chemical (Specialty) 70 1.28 21.2% Coal 20 1.53 28.9% Computer Software 184 1.04 7.5% Computers/Peripherals 87 1.30 10.2% Diversified Co. 107 1.14 102.2% Drug 279 1.12 15.5% E-‐Commerce 57 1.03 6.4% Tax Rate 10.7% 20.7% 20.5% 16.1% 19.0% 24.1% 16.0% 17.8% 19.1% 2.5% 11.2% 27.4% 20.9% 21.7% 17.6% 12.8% 12.3% 11.8% 15.6% 5.4% 12.3% Cash/ Firm Value 16.6% 11.8% 7.6% 7.9% 12.5% 17.8% 11.4% 14.1% 5.1% 21.5% 7.7% 6.1% 9.7% 7.4% 5.3% 7.7% 17.2% 10.7% 14.3% 9.2% 10.2% From Prof. Damodaran’s website at NYU
- 32. Return on Invested Capital 32 ¨ For financial decision making, the return to invested capital, roic, NOPAT, is needed ¤ ¨ Start with return to equity (net profit, NP) ¤ ¨ Net Opera-ng Profit AOer Tax NP = EBIT·∙(1 – τ) – IX·∙(1 – τ) For Fairway Corp, three adjustments are needed to transform NP to NOPAT 1. Subtract ‘non-‐opera-ng’ income n Effec-ve return on IDI: IDI·∙(1-‐τ) n IDI is revenue received in cash from NOCE and IS at Fairway
- 33. Return on Invested Capital 33 Three adjustments to transform NP to NOPAT ¨ 2. Add back effec-ve payment to debt providers: IX·∙(1-‐τ) IX is interest expense and is paid out in cash 3. ¨ ¨ Add back any provision for income taxes, IT, that accrues to capital, ΔT NOPAT = EBIT·∙(1 – τ) – IX·∙(1 – τ) -‐ IDI·∙(1-‐τ) + IX·∙(1-‐τ) + ΔT = (EBIT– IDI)(1 – τ) + ΔT EBIT……………………………… $ 370.00 For Fairway Corp IDI $ 19.00 EBIT-‐IDI…………….. 351.00 $ (EBIT-‐IDI)·∙(1-‐τ)…… 231.68 $ NOPAT = ($370 -‐ $19)(1-‐.34) + $5 ΔT $ 5.00 = $236.68 NOPAT…………………….. $ 236.68
- 34. Income Statement Extended For NOPAT 34 FAIRWAY CORPORATION Income Statement Extended to Return on Invested Capital For the Year Ended December 31, 2011 (in thousands) R………………………………… $ 3,190.00 COGS $ 2,290.00 Revenue Cost of goods s old GM……………………………… $ 900.00 OX $ 449.00 NX $ (39.00) Gross margin Operating expenses Other expenses (income) EBITDA……………………….. $ 490.00 DX $ 120.00 Earnings before interest, tax, and depreciation Depreciation expense EBIT……………………………… $ 370.00 IDI $ 19.00 EBIT-‐IDI…………….. 351.00 $ (EBIT-‐IDI)·∙(1-‐τ)…… 231.68 $ ΔT $ 5.00 Earnings before interest and tax Investment (non-‐operating) income NOPAT…………………….. $ 236.68 Return to invested capital Increase in deferred tax
- 35. Rate of Return on Invested Capital 35 roic = NOPAT NOPAT R = ⋅ IC R IC For Fairway Corp roic = NOPAT 1 ⋅ (IC i + IC i−1 ) 2 = $236.68 1 ⋅ ($2449 + $1952) 2 = 10.8%
- 36. Essen-al Points 36 ¨ Key finance concepts based on balance sheet and income statements ¤ ¤ ¤ ¨ ¨ Capital, C, and Invested Capital, IC Return on invested capital, NOPAT Rate of return on invested capital, roic Key financial decision making criterion: roic > k Understand financing v. opera-ng contribu-ons to return NP = EBIT(1 – τ) – IX(1 – τ) = EBIT(1 – τ) – IX + TS
- 37. References 37 ¨ Accoun-ng: Texts and Cases ¤ ¤ ¨ On the General Equivalence of Company Valua>on Models ¤ ¤ Robert Anthony , David Hawkins , Kenneth Merchant Harvard Joakim Levin Stockholm School of Economics