Fin 480E: Chapter 4

Front 1

Accrual

Back 1

A noncash value flow recorded in the financial statements. See also income statement accrual and balance sheet accrual. 127

Front 2

Annuity

Back 2

The annual amount in a constant stream of payoffs. 117

Front 3

Continuing value

Back 3

The value calculated at a forecast horizon that captures value added after the horizon. 120

Front 4

Dividend conundrum

Back 4

Refers to the following puzzle: The value of a share is based on expected dividends but forecasting dividends (over finite horizons) does not yield the value of the share. 118

Front 5

Historical cost accounting

Back 5

Measures investments at their cash cost and adjusts the cost with accruals. 134

Front 6

Matching principle

Back 6

The accounting principle that recognizes expenses when the revenue for which they are incurred is recognized. 128

Front 7

Perpetuity

Back 7

A periodic payoff that continues without end. 117

Front 8

Terminal value

Back 8

What an investment is expected to be worth in the future when it terminates or when it may be liquidated. 116

Front 9

Value of equity

Back 9

pg 116

Front 10

Value of equity (longer version)

Back 10

pg 116

Front 11

Perpetuity dividend model

Back 11

pg 116

Front 12

Dividend growth model

Back 12

pg 117

Front 13

Value of a perpetual dividend stream

Back 13

pg 117

Front 14

Value of a dividend growing at a constant rate

Back 14

pg 117

Front 15

Value of the firm (with PV FCF)

Back 15

pg 119

Front 16

Value of the equity (with PV FCF - Net debt value)

Back 16

pg 120

Front 17

If free cash flow after T are forecasted to be a (constant) perpetuity,

Back 17

pg 120

Front 18

If free cash flows are forecasted to grow at a constant rate after the horizon,

Back 18

pg 120

Front 19

Cash flow from operations

Back 19

pg 125

Front 20

Cash investment in operations

Back 20

pg 126

Front 21

Revenue

Back 21

pg 129

Front 22

Expense

Back 22

pg 130

Front 23

Earnings (answer w/ Leveraged cash flow)

Back 23

pg 130

Front 24

Earnings

Back 24

pg 130

Front 25

Cash flow from operations - Net interest payments (after tax) + Accruals =

Back 25

= Earnings (From CF from Ops)

Front 26

Free cashflow - Net interest payments (after tax) + Accruals + Investments =

Back 26

= Earnings (From FCF)

Front 27

Discounted Cash Flow Advantages

Back 27

Easy Concept: Cash flows are "real" and easy to think about; they are not affected by accounting rules.

Familiarity: Cash flow valuation is a straightforward application of familiar present value techniques.

Front 28

Discounted Cash Flow Disadvantages - Hint: Concept

Back 28

Suspect Concept: FCF 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 involved cash flows. Investment is treated as a loss of value. FCF is partly a liquidation concept; firms increase FCF by cutting back on investments.

Front 29

Discounted Cash Flow Disadvantages - Hint: Horizons

Back 29

Forecast Horizons: Typically, long forecast horizons are required to recognize cash inflows from investments, particularly when investments are growing. Continuing values have a high weight in the valuation.

Front 30

Discounted Cash Flow Disadvantages - Hint: People Forecast

Back 30

Not aligned with what people forecast: Analysts forecast earnings, not FCF; adjusting earnings forecasts to FCF forecasts requires further forecasting of accruals.

Front 31

Displacement

Back 31

Transference of emotions from the original object to some substitute or symbolic representation. Can be a factor in phobias.

Front 32

Dividend Discount Analysis Advantages

Back 32

Easy Concept: Dividends are what shareholders get, so forecast them.

Predictability: Dividends are usually fairly stable in the short run so dividends are easy to forecast (in the short run).

Front 33

Dividend Discount Analysis Disadvantages

Back 33

Relevance: Dividend payout is not related to value, at least in the short run; dividend forecasts ignore the capital gain component of payoffs.

Forecast horizons: Typically requires forecasts for long periods.

Front 34

Cash flow from operations - Net interest payments (after tax) + Accruals =

Back 34

= Earnings (From CF from Ops)

Front 35

Free cashflow - Net interest payments (after tax) + Accruals + Investments =

Back 35

= Earnings (From FCF)

Front 36

Discounted Cash Flow Advantages

Back 36

Easy Concept: Cash flows are "real" and easy to think about; they are not affected by accounting rules.

Familiarity: Cash flow valuation is a straightforward application of familiar present value techniques.

Front 37

Discounted Cash Flow Disadvantages - Hint: Concept

Back 37

Suspect Concept: FCF 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 involved cash flows. Investment is treated as a loss of value. FCF is partly a liquidation concept; firms increase FCF by cutting back on investments.

Front 38

Discounted Cash Flow Disadvantages - Hint: Horizons

Back 38

Forecast Horizons: Typically, long forecast horizons are required to recognize cash inflows from investments, particularly when investments are growing. Continuing values have a high weight in the valuation.

Front 39

Discounted Cash Flow Disadvantages - Hint: People Forecast

Back 39

Not aligned with what people forecast: Analysts forecast earnings, not FCF; adjusting earnings forecasts to FCF forecasts requires further forecasting of accruals.

Front 40

Displacement

Back 40

Transference of emotions from the original object to some substitute or symbolic representation. Can be a factor in phobias.

Front 41

Dividend Discount Analysis Advantages

Back 41

Easy Concept: Dividends are what shareholders get, so forecast them.

Predictability: Dividends are usually fairly stable in the short run so dividends are easy to forecast (in the short run).

Front 42

Dividend Discount Analysis Disadvantages

Back 42

Relevance: Dividend payout is not related to value, at least in the short run; dividend forecasts ignore the capital gain component of payoffs.

Forecast horizons: Typically requires forecasts for long periods.

Front 43

When Dividend Discount Analysis Works Best

Back 43

When payout is permanently tied to the value generation in the firm. For example, when a firm has a fixed payout ratio (dividends/earnings).

Front 44

Accrual Accounting: Examples of how affects Balance Sheet and Income Statement

Back 44

Front 45

Articulation of Financial Statements through the Recording of Cash Flows and Accruals between Time 0 and 1

Back 45

Front 46

Calculating FCFF from net income. FCFF is calculated from net income as:

Back 46

Front 47

Calculating FCFF and FCFE Using the Statement of Cash Flows Figure 2:

Back 47

Free cash flow to the firm is the operating cash flow left after the firm makes working
capital and fixed capital investment.

Front 48

Calculating FCFF from EBIT. FCFF can also be calculated from earnings before
interest and taxes (EBIT):

Back 48

If we start with earnings before interest and taxes (EBIT), we have to add back
depreciation because it was subtracted out to get to EBIT. However, because EBIT
is “before interest and taxes” we don’t have to take out interest (remember that it’s a
financing cash flow). We do have to adjust for taxes, though, by computing after-tax
EBIT, which is EBIT times one minus the tax rate. We also make the same adjustments
as we did before by subtracting out fixed capital and working capital investment.

Front 49

Calculating FCFF from EBITDA

Back 49

Remember that EBITDA is “before depreciation,” so we only have to add back
the depreciation tax shield, which is depreciation times the tax rate. Even though
depreciation is a noncash expense, the firm reduces its tax bill by expensing it, so the free
cash flow available is increased by the taxes saved.

Front 50

Calculating FCFF from CFO.

Back 50

Cash flow from operations is equal to net income plus noncash charges less working
capital investment. We have to add back to CFO the after-tax interest expense to get to
FCFF because interest expense (and the resulting tax shield) was reflected on the income
statement to arrive at net income. We also have to subtract out fixed capital investment
since CFO only includes changes in working capital investment.

Front 51

Which FCFF formula should you use on the exam?

Back 51

I suggest that, at
a minimum, you memorize the first one (that starts with net income) and the
last one (that starts with cash flow from operations). That way, given either an
income statement or a cash flow statement, you can calculate FCFF. However,
don’t be surprised if you’re required to know the other two as well.

Front 52

Calculating FCFE from FCFF.

Back 52

If we start with FCFF, we have to adjust for the two cash flows to bondholders to
calculate FCFE: the after-tax interest expense and any new long- or short-term
borrowings. We only subtract the after-tax interest expense because paying interest
reduces the firm’s tax bill and reduces the cash available to the shareholders by the
interest paid minus the taxes saved.

Front 53

Calculating FCFE from net income.

Back 53

We can also calculate FCFE from net income by
making some of the usual adjustments. The two differences between this “FCFE from
net income” formula and the “FCFF from net income formula” are (1) after-tax interest
expense is NOT added back and (2) net borrowing is added back.

Front 54

Calculating FCFE from CFO.

Back 54

Finally, we can calculate FCFE from CFO by subtracting
out fixed capital investment (which reduces cash available to shareholders) and adding
back net borrowing (which increases the cash available to shareholders).

Front 55

Firm Value Equation- The value of the firm is the present value of the expected future FCFF discounted at the
WACC (this is so important we’re going to repeat it as a formula):

Back 55

The weighted average cost of capital is the required return on the firm’s assets. It’s a
weighted average of the required return on common equity and the after-tax required
return on debt.


Technically, what we’ve called firm value is actually the value of
the operating assets (the assets that generate cash flow). Significant nonoperating
assets, such as excess cash (not total cash on the balance sheet), excess marketable
securities, or land held for investment should be added to this estimate to
calculate total firm value. Most of the time the value of these assets is small in
relation to the present value of the FCFFs, so we don’t lose much by ignoring
it. If you are asked to calculate the value of the firm using the FCFF approach,
calculate the present value of the FCFFs and then look for any additional
information in the problem that specifically says “excess cash and marketable
securities” or “land held for investment.”

Front 56

The value of the firm’s equity is the present value of the expected future FCFE
discounted at the required return on equity:

Back 56

Front 57

Given the value of the firm, we can also calculate equity value by simply subtracting out
the market value of the debt:

Back 57

This is an
extremely important concept, so memorize it now.

Front 58

FCFF and FCFE Exhibits

Back 58

Front 59

The amount that’s left after the firm has met all its obligations to its other investors is
called ____. However, the board
of directors still has discretion over what to do with that money. It could pay it all out
in dividends to its common shareholders, but it might decide to only pay out some
of it and put the rest in the bank to save for next year. That way, if FCFE is low the
next year, it won’t have to cut the dividend payment. So ____ is the cash available to
common shareholders after funding capital requirements, working capital needs, and
debt financing requirements.

Back 59

free cash flow to equity (FCFE)

Front 60

Cash flows into the firm in the form of
revenues as it sells its product, and cash flows out as it pays its cash operating expenses
(e.g., salaries and taxes, but not interest expense, which is a financing and not an
operating expense). The firm takes the cash that’s left over and makes short-term
net investments in working capital (e.g., inventory and receivables) and long-term
investments in property, plant, and equipment. The cash that remains is available to
pay out to the firm’s investors: bondholders and common shareholders (let’s assume for
the moment that the firm has not issued preferred stock). That pile of remaining cash
is called ______ because it’s “free” to pay out to the firm’s
investors (see Figure 1). The formal definition of ____ is the cash available to all of the
firm’s investors, including stockholders and bondholders, after the firm buys and sells
products, provides services, pays its cash operating expenses, and makes short- and long-
term investments.



Taxes paid are included in the definition of cash operating
expenses for purposes of defining free cash flow, even though taxes aren’t generally
considered a part of operating income.

Back 60

free cash flow to the firm (FCFF)

Front 61

What does the firm do with its FCFF?

Back 61

First, it takes care of its bondholders because
common shareholders are last in line at the money store. So it makes interest payments

to bondholders and borrows more money from them or pays some of it back. However,
making interest payments to bondholders has one advantage for common shareholders:
it reduces the tax bill.

Front 62

Common Mistakes with FCF Valuation

Back 62

Using the wrong discount rate or the
wrong cash flow definition. Remember, always discount FCFF at the WACC to
find firm value and FCFE at the required return on equity to estimate equity
value!

Front 63

Differences between FCFF and FCFE

Back 63

The differences between FCFF and FCFE account for differences in capital structure
and consequently reflect the perspectives of different capital suppliers. FCFE is easier
and more straightforward to use in cases where the company’s capital structure is not
particularly volatile. On the other hand, if a company has negative FCFE and significant
debt outstanding, FCFF is generally the best choice. We can always estimate equity value
indirectly by discounting FCFF to find firm value and then subtracting out the market
value of debt to arrive at equity value.

Front 64

Noncash charges. Noncash charges are added back to net income to arrive at FCFF
because they represent expenses that reduced reported net income but didn’t actually
result in an outflow of cash. The most significant noncash charge is usually depreciation.
Here are some other examples of noncash charges that often appear on the cash flow
statement:

Back 64

Front 65

Fixed capital investment. Investments in fixed capital do not appear on the income
statement, but they do represent cash leaving the firm. That means we have to subtract
them from net income to estimate FCFF. Fixed capital investment is a net amount: it
is equal to the difference between capital expenditures (investments in long-term fixed
assets) and the proceeds from the sale of long-term assets:

Back 65

Both capital expenditures and proceeds from long-term asset sales (if any) are likely to
be reported on the firm’s statement of cash flows. If no long-term assets were sold during
the year, then capital expenditures will also equal the change in the gross PP&E account
from the balance sheet. Note that if long-term assets were sold during the year, any gain
or loss on the sale is handled as a non-cash item as previously discussed.
So what is the Level 2 candidate supposed to do on exam day to calculate FCInv? Let’s
examine two cases: first, if no long term assets were sold during the year, and second, if
the company did sell long term assets.

Front 66

If no long term assets were sold during the year, then FCInv is simply equal to the change
in the gross PP&E account:

Back 66

Front 67

If long term assets were sold during the year, then:

Back 67

Front 68

Back 68

Front 69

Back 69

Front 70

Revenue for a period is calculated as:

Back 70

Revenue = Cash receipts from sales + New sales on credit - Cash received for previous periods' sales - Estimated sales returns - Deferred revenue for cash received in advance of sale + Revenue previously deferred to the current period

Front 71

Cash payments are modified by accruals as follows:

Back 71

Expense = Cash paid for expenses + Amounts incurred in generating revenues but not yet paid - Cash paid for generating revenues in future periods + Amounts paid in the past for generating revenues in the current period.

Front 72

Reported cash flows from operations are after interest, so Earnings are:

Back 72

Earnings = Levered cash flow from operations + Accruals

Earnings = (C-i) + Accruals

Front 73

Earnings based off of value generated from Investments . The value lost in operations occurs after the cash flow:

Back 73

Earnings = Free Cash flow - Net cash interest + Investments + Accruals

Earnings = (C-I) - i - I + Accruals