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Chapter 4

Chapter 4. Prepared by: Nir Yehuda With contributions by Stephen H. Penman – Columbia University Peter D. Easton and Gregory A. Sommers - Ohio State University Luis Palencia – University of Navarra, IESE Business School. What you will learn from this Chapter.

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Chapter 4

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  1. Chapter 4 Prepared by: Nir Yehuda With contributions by Stephen H. Penman – Columbia University Peter D. Easton and Gregory A. Sommers - Ohio State University Luis Palencia – University of Navarra, IESE Business School

  2. What you will learn from this Chapter • What is meant by cash flow from operations • What is meant by cash used in investing activities • What is meant by free cash flow • How discounted cash flow valuation works • Problems that arise in applying cash flow valuation • Why free cash flow may not measure value added in operations • Why free cash flow is a liquidation concept • How discounted cash flow valuation involves cash accounting for operating activities • Why “cash flow from operations” reported in U.S. financial statements does not measure operating cash flows correctly • Why “cash flows in investing activities” reported in U.S. financial statements does not measure cash investment in operations correctly • How accrual accounting for operations differs from cash accounting for operations • The difference between earnings and cash flow from operations • The difference between earnings and free cash flow • How accruals and the accounting for investment affect the balance sheet as well as the income statement • Why analysts forecast earnings rather than cash flows • How a valuation model is a model of accounting for the future

  3. C1 C3 C4 C5 C2 I4 I1 I2 I3 I5 C3-I3 C1-I1 C4-I4 C5-I5 C2-I2 1 2 3 4 5 Cash Flows for a Going Concern Free cash flow is cash flow from operations that results from investments minus cash used to make investments. • Cash flow from operations (inflows) • Cash investment (outflows) • Free cash flow • Time, t

  4. The Discounted Cash Flow Model (DCFM)

  5. The Continuing Value for the DCFM A. Capitalize terminal free cash flow B. Capitalize terminal free cash flow with growth Will it work?

  6. DCF Valuation: New York State Electric and Gas

  7. Simple Valuations • Simple valuations make valuations solely from information in the financial statements. They avoid analysis and avoid forecasting. They can work, but beware ! A simple DCF valuation for NY State Electric and Gas, 1996 Another simple valuation where g is a growth rate

  8. Wal-Mart Stores, Inc. (Fiscal years ending January 31. Amounts in millions of dollars.) 1988 1989 1990 1991 1992 1993 1994 1995 1996 Cash from operations 536 828 968 1,422 1,553 1,540 2,573 3,410 2,993 Cash investments 627 541 894 1,526 2,150 3,506 4,486 3,792 3,332 Free cash flow (91) 287 74 (104) (597) (1,966) (1,913) (382) (339) Dividends per share 0.03 0.04 0.06 0.07 0.09 0.11 0.13 0.17 0.20 Price per share 6⅞ 8½ 10⅝ 16½ 27 32½ 26½ 25⅞ 24⅜ The DCFM: Will it work for Wal-Mart Stores?

  9. Why Free Cash Flow is not a Value-Added Concept • Cash flow from operations (value added) is reduced by investments (which also add value): investments are treated as value losses • Value received is not matched against value surrendered to generate value - except for long forecast horizons Note: a firm reduces free cash flow by investing and increases free cash flow by reducing investments: free cash flow is partially a liquidation concept Note: analysts forecast earnings, not cash flows

  10. Advantages Easy concept: cash flows are “real” and easy to think about; they are not affected by accounting rules Familiarity: is a straight application of familiar net present value techniques Disadvantages Suspect concept: free cash flow does not measure value added in the short run; value gained is not matched with value given up. free cash flow fails to recognize value generated that does not involve cash flows investment is treated as a loss of value free cash flow is partly a liquidation concept; firms increase free cash flow by cutting back on investments. Forecast horizons: typically requires forecasts for long periods; terminal values for shorter periods are hard to calculate with any reliability Validation: it is hard to validate free cash flow forecasts Not aligned with what people forecast: analysts forecast earnings, not free cash flow; adjusting earnings forecasts to free cash forecasts requires further forecasting of accruals. Discounted Cash Flow Analysis: Advantages and Disadvantages • When It Works Best • When the investment pattern is such as to produce constant free cash flow or free cash flow growing at a constant rate.

  11. Statement of Cash Flows: Dell Computer

  12. Reported Cash Flow from Operations Reported cash flows from operations in U.S. cash flow statements is after interest: Cash Flow from Operations = Reported Cash Flow from Operations + After-tax Net Interest Payments After-tax Net Interest = Net Interest x (1 - tax rate) Net interest = Interest payments – Interest receipts Reported cash flow from operations is sometimes referred to as levered cash flow from operations

  13. Reported Cash Flow in Investing Activities Reported cash investments include net investments in interest bearing financial assets (excess cash): Cash investment in operations = reported cash flow from investing - net investment in interest-bearing securities

  14. Calculating Free Cash Flow: Dell Computer, 2002 Reported cash flow from operations 3,797 Interest payments 31 Interest income* (314) Net interest payments (283) Taxes (35%) †99 Net interest payments after tax (65%) (184) Cash flow from operations 3,613 Reported cash used in investing activities 2,260 Purchases of interesting-bearing securities 5,382 Sales of interest-bearing securities (3,425) 1,957 Cash investment in operations 303 Free cash flow 3,310 *Interest payments are given as supplemental data to the statement of cash flows, but interest receipts usually are not. Interest income (from the income statement) is used instead; this includes accruals but is usually close to the cash interest received. †Dell’s statutory tax rate (for federal and state taxes) is 35 percent, as indicated in the financial Statement footnotes.

  15. Forecasting Free Cash Flows • It is difficult to forecast free cash flows without forecasting earnings. First forecast earnings and then make adjustments to convert earnings to cash flow from operations. Follow the following steps: • Forecast earnings available to common • Forecast accruals (the difference between earnings and cash flow from operations in the cash flow statement) • Calculate levered cash flow from operations (Step (i) - Step (ii)) • Calculate unlevered cash flow from operations by adding after-tax net interest • Forecast cash investments in operations • Calculate forecasted free cash flow, C - I (Step (iv) - Step (v))

  16. Forecast 2000 2001 2002 Earnings 1,666 2,177 1,246 Accrual adjustment 2,260 2,018 2,551 Levered cash flows from operations 3,926 4,195 3,797 Interest payments 34 49 31 Interest receipts (158) (305) (314 ) Net interest payments (124) (256) (283) Tax at 35% 43 (81) 9 0 (166) 99 (184) Cash flow from operations 3,845 4,029 3,613 Cash investment in operations (401 ) (482) (303) Free cash flow 3,444 3,547 3,310 Forecasting Free Cash Flow: Dell Computer

  17. Features of the Income Statement 1. Dividends don’t affect income 2. Investment doesn’t affect income 3. There is a matching of • Value added (revenues) • Value lost (expenses) • Net value added (net income) 4. Accruals adjust cash flows Accruals Value added that is not cash flow Adjustments to cash inflows that are not value added

  18. The Income Statement: Dell Computer

  19. The Revenue Calculation Revenue = Cash receipts from sales + New sales on credit  Cash received for previous periods' sales  Estimates of credit sales not collectible  Estimated sales returns and rebates  Deferred revenue for cash received in advance of sale + Revenue previously deferred

  20. The Expense Calculation Expense = Cash paid for expenses + Amounts incurred in generating revenue but not yet paid  Cash paid for generating revenues in future periods + Amounts paid in the past for generating revenues in the current period

  21. Earnings and Cash Flows Earnings = [C - I] - i + I + accruals = C - i + accruals • The earnings calculation adds back investments and puts them back in the balance sheet. It also adds accruals.

  22. Earnings and Cash Flows: Wal-Mart Stores

  23. Accruals, Investments and the Balance Sheet Accruals and investments are put in the balance sheet Shareholders’ equity = Cash + Other Assets - Liabilities Earnings Cash from Operations Accruals Free cash flow Cash from Operations Investments

  24. The Balance Sheet: Dell Computer

  25. The articulation of the financial statements through the recording of cash flows and accruals Net cash flows from all activities increases cash in the balance sheet Cash from operations increases net income and shareholders’ equity Cash investments increase other assets Cash from debt financing increases liabilities Cash from equity financing increases shareholders’ equity Accruals increase net income, shareholders’ equity, assets and liabilities

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