Slides - Session 5

FINA 410 – Section AA – Summer 2021
ØDepartment of Finance, John Molson School of Business, Concordia University

ØCourse Title: Investment Analysis
ØTextbook: Damodaran (2012) Investment Valuation: Tools and Techniques for Determining the
Value of any Asset, Wiley; 3rd edition
• Session 5 – Wednesday, May 26th
o Chapter 09 (Measuring Earnings)

o Chapter 10 (From Earnings to Cash Flows)
• Instructor: Moein Karami (Email: [email protected])

0
Agenda
1. CH 09: Measuring Earnings

2. CH 10: From Earnings to Cash Flows
Moein Karami (FINA 410/AA - Summer 2021 - Session 5) 1

Recap Example
ØFind the present value (PV0) of the investment with the following set of projections and
assumptions:
• Given values (assumptions) are specified in the next slide Table (blue) [The rest of the
values are calculated based on assumptions].
• Assume we are now 6 months into year 1, i.e., the first FCF is within 6 month (end of
year 1).
• Depreciation and Amortization Expenses are expected to grow at a rate equal to
revenues growth rate until year 6.
• Tax rate= 35%.
• FCFs are expected to grow at a constant rate of 3% after year 5.
• Discount rate considering the risk of the investment is estimated at 23%.
2
Recap Example
Solution
Excel

Recap Example – Solution - continued
!"# (,*++,(*,
• TV6 = = = $17,556,750
$%& ,..(%,.,(
• Remember we are at “month6”, so we discount everything back to there (using effective
annual rate as “k”, and fraction of years to discount as “N”).
!"+ !". !"( !"= !"* !"@ AB@
• PV0 = + + + + + + (Calculate)
(+6$)8.9 (+6$);.9 (+6$)<.9 (+6$)>.9 (+6$)?.9 (+6$)9.9 (+6$)9.9
• You can alternatively, use financial calculator, discount everything back to t=0, and then
compound it as a single cash flow to N=0.5 (after 6 months) by multiplying (1+k)^0.5.
0.23

1. CH 09:
Measuring
Earnings
5
Steps in Cash Flow Estimation
• Estimate the current earnings of the firm
• If looking at cash flows to equity, look at earnings after interest expenses - i.e.
net income
• If looking at cash flows to the firm, look at operating earnings after taxes
• Consider how much the firm invested to create future growth
• If the investment is not expensed, it will be categorized as capital
expenditures. To the extent that depreciation provides a cash flow, it will
cover some of these expenditures.
• Increasing working capital needs are also investments for future growth
• If looking at cash flows to equity, consider the cash flows from net
debt issues (debt issued - debt repaid)

Measuring Cash Flows
Cash flows can be measured to
Just Equity Investors

All claimholders in the firm
EBIT (1- tax rate) Net Income Dividends

- ( Capital Expenditures - Depreciation) - (Capital Expenditures - Depreciation) + Stock Buybacks
- Change in non-cash working capital - Change in non-cash Working Capital
= Free Cash Flow to Firm (FCFF) - (Principal Repaid - New Debt Issues)
- Preferred Dividend

Measuring Cash Flow to the Firm
EBIT ( 1 - tax rate)
- (Capital Expenditures - Depreciation)
- Change in Working Capital
= Cash flow to the firm
• Where are the tax savings from interest payments in this cash flow?
The tax savings from interest payments do not show up in the cashflows
because they have already been counted in the cost of capital (in the use
of the after-tax cost of debt). If you add the interest tax benefits to the
cashflows, you will double count the benefit.
Earnings
• To estimate cash flows, we usually begin with a measure of earnings.
• Free cash flows to the firm, for instance, are based on after-tax operating earnings.
• Free cash flows to equity estimates, on the other hand, commence with net income.
üOperating income is revenue less any operating expenses, while net

income is operating income less any other non-operating expenses, such as
interest and taxes.
üOperating income includes expenses such as selling, general & administrative
expenses (SG&A), and depreciation and amortization.
üNet income (also called the bottom line) can include additional income like
interest income or the sale of assets.

Accounting vs. Financial Balance Sheet
• A firm, as defined here, includes both investments already made—assets in place—and
investments yet to be made—growth assets. In addition, a firm can either borrow the
funds it needs to make these investments, in which case it is using debt, or raise it from
its owners in the form of equity.

Accounting vs. Financial Balance Sheet-continued
• A firm, as defined here, includes both investments already made—assets in place—and
investments yet to be made—growth assets. In addition, a firm can either borrow the
funds it needs to make these investments, in which case it is using debt, or raise it from
its owners in the form of equity.

Accounting Principles underlying Asset Measurement
An asset is any resource that has the potential either to generate future cash inflows or
to reduce future cash outflows.
The accounting view of asset value is to a great extent grounded in the notion of historical
cost, which is the original cost of the asset, adjusted upward for improvements made to
the asset since purchase and downward for the loss in value associated with the aging of
the asset. This historical cost is called the book value.
Adjusting Earnings:
The income statement for a firm provides measures of both the operating and equity
income of the firm in the form of the earnings before interest and taxes (EBIT) and net
income.
When valuing firms, there are two important considerations in using these measures:
1. To obtain as updated an estimate as possible, given how much firms change over time.
2. Reported earnings at these firms may bear little resemblance to true earnings because
of limitations in accounting rules and the firms' own actions.

Adjustments to Calculate Earnings
• While we obtain measures of operating and net income from accounting
statements, the accounting earnings for many firms bear little or no resemblance
to the true earnings of the firm!
• difference between the accounting and financial views of firms?

• how the earnings of a firm, at least as measured by accountants, have to be
adjusted to get a measure of earnings that is more appropriate for valuation?
• In particular, we examine how to treat operating lease expenses, which we argue
are really financial expenses, and research and development expenses, which we
consider to be capital expenses.
The adjustments affect not only our measures of earnings but our estimates of
book value of capital!

Importance of Updating Earnings
Firms reveal their earnings in their financial statements and annual reports to stockholders.
Annual reports are released only at the end of a firm's financial year, but you are often
required to value firms all through the year.
Consequently, the last annual report that is available for a firm being valued can contain
information that is several months old. In the case of firms that are changing rapidly over
time, it is dangerous to base value estimates on information that is this old.
ØInstead, use more recent information. Since firms in the United States are required to file
quarterly reports with the Securities and Exchange Commission (10-Qs) and reveal these
reports to the public, a more recent estimate of key items in the financial statements can
be obtained by aggregating the numbers over the most recent four quarters. The
estimates of revenues and earnings that emerge from this exercise are called trailing 12-
month revenues and earnings and can be very different from the values for the same
variables in the most recent annual report.

I. Update Earnings
• When valuing companies, we often depend upon financial statements for
inputs on earnings and assets. Annual reports are often outdated and can
be updated by using-
• Trailing 12-month data, constructed from quarterly earnings reports.
• Informal and unofficial news reports, if quarterly reports are unavailable.
• Updating makes the most difference for smaller and more volatile firms, as
well as for firms that have undergone significant restructuring.
• Time saver: To get a trailing 12-month number, all you need is one 10K and
one 10Q (example third quarter). Use the Year to date numbers from the
10Q:
Trailing 12-month Revenue = Revenues (in last 10K) - Revenues from first 3 quarters of
last year + Revenues from first 3 quarters of this year.

Example 1

II. Correcting Accounting Earnings
• Make sure that there are no financial expenses mixed in with operating
expenses
• Financial expense: Any commitment that is tax deductible that you have to meet no
matter what your operating results: Failure to meet it leads to loss of control of the
business.
• Example: Operating Leases: While accounting convention treats operating leases as
operating expenses, they are really financial expenses and need to be reclassified as
such. This has no effect on equity earnings but does change the operating earnings
• Make sure that there are no capital expenses mixed in with the operating
expenses
• Capital expense: Any expense that is expected to generate benefits over multiple
periods.
• R & D Adjustment: Since R&D is a capital expenditure (rather than an operating
expense), the operating income has to be adjusted to reflect its treatment.

From Reported to Actual Earnings
Operating leases R&D Expenses
Firmʼs Comparable - Convert into debt - Convert into asset
history Firms - Adjust operating income - Adjust operating income
Normalize Cleanse operating items of

Earnings - Financial Expenses
- Capital Expenses
- Non-recurring expenses
Measuring Earnings
Update
- Trailing Earnings
- Unofficial numbers

Operating Leases
• An operating lease is a contract that allows for the use of an asset but does not
convey ownership rights of the asset.
• Operating leases are considered a form of off-balance-sheet financing—meaning

a leased asset and associated liabilities (i.e. future rent payments) are not
included on a company's balance sheet.
• Historically, operating leases have enabled American firms to keep billions of

dollars of assets and liabilities from being recorded on their balance sheets,
thereby keeping their debt-to-equity ratios low

Operating Leases-continued
• GAAP rules govern accounting for operating leases.
• A new FASB rule, effective Dec. 15, 2018, requires that all leases—
unless they are shorter than 12 months—must be recognized on the
balance sheet.

Dealing with Operating Lease Expenses
• Operating Lease Expenses are treated as operating expenses in computing
operating income. In reality, operating lease expenses should be treated as
financing expenses, with the following adjustments to earnings and capital:
• Debt Value of Operating Leases = Present value of Operating Lease
Commitments at the pre-tax cost of debt
• When you convert operating leases into debt, you also create an asset to
counter it of exactly the same value.
• Adjusted Operating Earnings
Adjusted Operating Earnings = Operating Earnings + Operating Lease Expenses -
Depreciation on Leased Asset
• As an approximation, this works:
Adjusted Operating Earnings = Operating Earnings + Pre-tax cost of Debt * PV of
Operating Leases.

The Magnitude of Operating Leases
Operating Lease expenses as % of Operating Income
60.00%
50.00%
40.00%
30.00%
20.00%
10.00%
0.00%
Market Apparel Stores Furniture Stores Restaurants

Operating Leases at The Gap in 2003
• The Gap has conventional debt of about $ 1.97 billion on its balance sheet and its pre-tax
cost of debt is about 6%. Its operating lease payments in the 2003 were $978 million and
its commitments for the future are below:
Year Commitment (millions) Present Value (at 6%)
1 $899.00 $848.11
2 $846.00 $752.94
3 $738.00 $619.64
4 $598.00 $473.67
5 $477.00 $356.44
6&7 $982.50 each year $1,346.04
Debt Value of leases = $4,396.85 (Also value of leased asset)
• Debt outstanding at The Gap = $1,970 m + $4,397 m = $6,367 m

• Adjusted Operating Income = Stated OI + OL exp this year - Deprec n
= $1,012 m + 978 m - 4397 m /7 = $1,362 million (7 year life for assets)
• Approximate OI = $1,012 m + $ 4397 m (.06) = $1,276 m

The Collateral Effects of Treating Operating
Leases as Debt
C o nventional Accounting Operating Leases Treated as Debt
Income Statement Income Statement
EBIT& Leases = 1,990 EBIT& Leases = 1,990
- Op Leases = 978 - Deprecn: OL= 628
EBIT = 1,012 EBIT = 1,362
Interest expense will rise to reflect the conversion
of operating leases as debt. Net income should
not change.
Balance Sheet Balance Sheet
Off balance sheet (Not shown as debt or as an Asset Liability
asset). Only the conventional debt of $1,970 OL Asset 4397 OL Debt 4397
million shows up on balance sheet Total debt = 4397 + 1970 = $6,367 million
Cost of capital = 8.20%(7350/9320) + 4% Cost of capital = 8.20%(7350/13717) + 4%

(1970/9320) = 7.31% (6367/13717) = 6.25%
Cost of equity for The Gap = 8.20%
After-tax cost of debt = 4%
Market value of equity = 7350
Return on capital = 1012 (1-.35)/(3130+1970) Return on capital = 1362 (1-.35)/(3130+6367)
= 12.90% = 9.30%

R&D Expenses: Operating or Capital Expenses
• Accounting standards require us to consider R&D as an operating
expense even though it is designed to generate future growth. It is
more logical to treat it as capital expenditures.
• To capitalize R&D,
• Specify an amortizable life for R&D (2 - 10 years)
• Collect past R&D expenses for as long as the amortizable life
• Sum up the unamortized R&D over the period. (Thus, if the amortizable life is
5 years, the research asset can be obtained by adding up 1/5th of the R&D
expense from five years ago, 2/5th of the R&D expense from four years ago...:

The Magnitude of R&D Expenses
R&D as % of Operating Income
60.00%
50.00%
40.00%
30.00%
20.00%
10.00%
0.00%
Market Petroleum Computers

Capitalizing R&D Expenses: SAP
• R & D was assumed to have a 5-year life.
Year R&D Expense Unamortized portion Amortization this year
Current 1020.02 1.00

-1 993.99 0.80 795.19 € 198.80
-2 909.39 0.60 545.63 € 181.88
-3 898.25 0.40 359.30 € 179.65
-4 969.38 0.20 193.88 € 193.88
-5 744.67 0.00 0.00 € 148.93
Value of research asset = € 2,914 million
Amortization of research asset in 2004 = € 903 million
Increase in Operating Income = 1020 - 903 = € 117 million
The Effect of Capitalizing R&D at SAP
C o nventional Accounting R&D treated as capital expenditure
Income Statement Income Statement
EBIT& R&D = 3045 EBIT& R&D = 3045
- R&D = 1020 - Amort: R&D = 903
EBIT = 2025 EBIT = 2142 (Increase of 117 m)
EBIT (1-t) = 1285 m EBIT (1-t) = 1359 m
Ignored tax benefit = (1020-903)(.3654) = 43
Adjusted EBIT (1-t) = 1359+43 = 1402 m
(Increase of 117 million)
Net Income will also increase by 117 million
Balance Sheet Balance Sheet
Off balance sheet asset. Book value of equity at Asset Liability
3,768 million Euros is understated because R&D Asset 2914 Book Equity +2914
biggest asset is off the books. Total Book Equity = 3768+2914= 6782 mil
Capital Expenditures Capital Expenditures
Conventional net cap ex of 2 million Euros Net Cap ex = 2+ 1020 – 903 = 119 mil
Cash Flows Cash Flows
EBIT (1-t) = 1285 EBIT (1-t) = 1402
- Net Cap Ex = 2 - Net Cap Ex = 119
FCFF = 1283 FCFF = 1283 m
Return on capital = 1285/(3768+530) Return on capital = 1402/(6782+530)
= 29.90% = 19.93%

III. One-Time and Non-recurring Charges
• Assume that you are valuing a firm that is reporting a loss of $ 500
million, due to a one-time charge of $ 1 billion. What is the earnings
you would use in your valuation?
❏A loss of $ 500 million
❏A profit of $ 500 million
Would your answer be any different if the firm had reported one-time
losses like these once every five years?
❏Yes
❏No

III. One-Time and Non-recurring Charges-
continued
• If it is truly a one-time change, you should use a profit of $ 500
million.
• If the firm is playing games (consolidating expenses and reporting
them as one-time charges every five years), you should take the
average annual expense of $ 200 million (1/5 of $ 1 billion) and
estimate a profit of $ 300 million.
• Don t take company characterizations of non-recurring charges at face

value. Look at the firm s history.

IV. Accounting Malfeasance….
• Though all firms may be governed by the same accounting standards, the
fidelity that they show to these standards can vary. More aggressive firms
will show higher earnings than more conservative firms.
• While you will not be able to catch outright fraud, you should look for
warning signals in financial statements and correct for them:
• Income from unspecified sources - holdings in other businesses that are not revealed
or from special purpose entities.
• Income from asset sales or financial transactions (for a non-financial firm)
• Sudden changes in standard expense items - a big drop in S,G &A or R&D expenses as
a percent of revenues, for instance.
• Frequent accounting restatements
• Accrual earnings that run ahead of cash earnings consistently
• Big differences between tax income and reported income

What tax rate?
• The tax rate that you should use in computing the after-tax operating
income should be
❏The effective tax rate in the financial statements (taxes paid/Taxable
income)
❏The tax rate based upon taxes paid and EBIT (taxes paid/EBIT)
❏The marginal tax rate for the country in which the company operates
❏The weighted average marginal tax rate across the countries in which the
company operates
❏None of the above
❏Any of the above, as long as you compute your after-tax cost of debt using
the same tax rate
What tax rate?-continued
• The effective tax rate is defined as taxes paid/ taxable income, as
defined in the reporting books. The marginal tax rate is the tax rate on
the last dollar of income. The effective tax rate is lower than the
marginal tax rate for most firms. Why?
• Bracket creep: Can be a reason for small private businesses but not for large
publicly traded firms where most of the income is at the highest marginal tax
rate anyway.
• Cosmetic factors: Two sets of books with different accounting standards for
tax and reporting books.
• Real factors: Capacity to defer taxes to the future.

The Right Tax Rate to Use
• The choice really is between the effective and the marginal tax rate. In
doing projections, it is far safer to use the marginal tax rate since the
effective tax rate is really a reflection of the difference between the
accounting and the tax books.
• By using the marginal tax rate, we tend to understate the after-tax
operating income in the earlier years, but the after-tax tax operating
income is more accurate in later years
• If you choose to use the effective tax rate, adjust the tax rate towards
the marginal tax rate over time.
• While an argument can be made for using a weighted average marginal tax
rate, it is safest to use the marginal tax rate of the country

The Right Tax Rate to Use-continued
• If you have a choice, you would prefer to do valuation with the tax books in front
of you, but since you do not have that choice as an outsider you have to choose
between the effective tax rate and the marginal tax rate.
• If you use the effective tax rate all the way through, you are assuming that taxes
can be deferred forever. This is unrealistic - tax deferrals catch up with you as
your growth flags - and will result in an overvaluation of your firm.
• If you use a marginal tax rate, you are assuming that you cannot defer taxes from
this point on. This is far too conservative and will yield too low a value for your
firm.
• Suggestion: Start with the effective tax rate in the early years and move towards
the marginal tax rate in the terminal year.

Net Capital Expenditures
• Net capital expenditures represent the difference between capital
expenditures and depreciation. Depreciation is a cash inflow that pays
for some or a lot (or sometimes all of) the capital expenditures.
• In general, the net capital expenditures will be a function of how fast
a firm is growing or expecting to grow. High growth firms will have
much higher net capital expenditures than low growth firms.
• Assumptions about net capital expenditures can therefore never be
made independently of assumptions about growth in the future.

Capital expenditures should include
• Research and development expenses, once they have been re-categorized
as capital expenses. The adjusted net cap ex will be
Adjusted Net Capital Expenditures = Net Capital Expenditures + Current year s R&D
expenses - Amortization of Research Asset
• Acquisitions of other firms, since these are like capital expenditures. The
adjusted net cap ex will be
Adjusted Net Cap Ex = Net Capital Expenditures + Acquisitions of other firms -
Amortization of such acquisitions
Two caveats:
1. Most firms do not do acquisitions every year. Hence, a normalized measure of
acquisitions (looking at an average over time) should be used
2. The best place to find acquisitions is in the statement of cash flows, usually
categorized under other investment activities

Working Capital Investments
• In accounting terms, the working capital is the difference between current
assets (inventory, cash and accounts receivable) and current liabilities
(accounts payables, short term debt and debt due within the next year)
• A cleaner definition of working capital from a cash flow perspective is the
difference between non-cash current assets (inventory and accounts
receivable) and non-debt current liabilities (accounts payable)
• Any investment in this measure of working capital ties up cash. Therefore,
any increases (decreases) in working capital will reduce (increase) cash
flows in that period.
• When forecasting future growth, it is important to forecast the effects of
such growth on working capital needs, and building these effects into the
cash flows.
Working Capital: General Propositions
• Changes in non-cash working capital from year to year tend to be
volatile. A far better estimate of non-cash working capital needs,
looking forward, can be estimated by looking at non-cash working
capital as a proportion of revenues
• Some firms have negative non-cash working capital. Assuming that
this will continue into the future will generate positive cash flows for
the firm. While this is indeed feasible for a period of time, it is not
forever. Thus, it is better that non-cash working capital needs be set
to zero, when it is negative.

Dividends and Cash Flows to Equity
• In the strictest sense, the only cash flow that an investor will receive from
an equity investment in a publicly traded firm is the dividend that will be
paid on the stock.
• Actual dividends, however, are set by the managers of the firm and may be
much lower than the potential dividends (that could have been paid out)
• managers are conservative and try to smooth out dividends
• managers like to hold on to cash to meet unforeseen future contingencies and
investment opportunities
• When actual dividends are less than potential dividends, using a model
that focuses only on dividends will under state the true value of the equity
in a firm.

Measuring Potential Dividends
• Some analysts assume that the earnings of a firm represent its potential
dividends. This cannot be true for several reasons:
• Earnings are not cash flows, since there are both non-cash revenues and expenses in
the earnings calculation
• Even if earnings were cash flows, a firm that paid its earnings out as dividends would
not be investing in new assets and thus could not grow
• Valuation models, where earnings are discounted back to the present, will over
estimate the value of the equity in the firm
• The potential dividends of a firm are the cash flows left over after the firm
has made any investments it needs to make to create future growth and
net debt repayments (debt repayments - new debt issues)
• The common categorization of capital expenditures into discretionary and non-
discretionary loses its basis when there is future growth built into the valuation.

2. CH 10: From Earnings to Cash Flows
42
Estimating Cash Flows: FCFE
• Cash flows to Equity for a Levered Firm
Net Income
- (Capital Expenditures - Depreciation)
- Changes in non-cash Working Capital
- (Principal Repayments - New Debt Issues)
= Free Cash flow to Equity
• preferred dividends are ignored. If preferred stock exist, preferred dividends

will also need to be netted out.

Estimating FCFE when Leverage is Stable
Net Income
- (1- d) (Capital Expenditures - Depreciation)
- (1- d) Working Capital Needs
= Free Cash flow to Equity
d = Debt/Capital Ratio
For this firm,
• Proceeds from new debt issues = Principal Repayments + d (Capital Expenditures -
Depreciation + Working Capital Needs)
• In computing FCFE, the book value debt to capital ratio should be used
when looking back in time but can be replaced with the market value debt
to capital ratio, looking forward.
FCFE and Leverage: Is this a free lunch?
Debt Ratio and FCFE: Disney
1600
1400
1200
1000
FCFE
800
600
400
200
0
0% 10% 20% 30% 40% 50% 60% 70% 80% 90%
Debt Ratio

FCFE and Leverage: The Other Shoe Drops
But the higher leverage increases the beta for the firm as well. The
levered beta equation developed earlier is used. The unlevered beta is
1.09 and the tax rate is 36%:
Levered Beta = 1.09 ( 1 + (1-.36) (Debt/Equity))
Debt Ratio and Beta
8.00
7.00
6.00
5.00
Beta
4.00
3.00
2.00
1.00
0.00
0% 10% 20% 30% 40% 50% 60% 70% 80% 90%
Debt Ratio

Leverage, FCFE and Value
• In a discounted cash flow model, increasing the debt/equity ratio will generally increase the
expected free cash flows to equity investors over future time periods and also the cost of equity
applied in discounting these cash flows. Which of the following statements relating leverage to
value would you subscribe to?
❏ Increasing leverage will increase value because the cash flow effects will dominate the discount
rate effects
❏ Increasing leverage will decrease value because the risk effect will be greater than the cash flow
effects
❏ Increasing leverage will not affect value because the risk effect will exactly offset the cash flow
effect
❏ Any of the above, depending upon what company you are looking at and where it is in terms of
current leverage
• Any of the above, if you believe that value can be affected by leverage and that there is an
optimal debt ratio.
• The third choice if you are a true believer in Miller-Modigliani I (that leverage does not affect
value) Moein Karami (FINA 410/AA - Summer 2021 - Session 5) 47
Good Luck!

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FINA 410 – Section AA – Summer 2021

ØDepartment of Finance, John Molson School of Business, Concordia University

• Session 5 – Wednesday, May 26th

o Chapter 09 (Measuring Earnings)

• Instructor: Moein Karami (Email: [email protected])

1. CH 09: Measuring Earnings

Moein Karami (FINA 410/AA - Summer 2021 - Session 5) 1

Moein Karami (FINA 410/AA - Summer 2021 - Session 5) 3

Moein Karami (FINA 410/AA - Summer 2021 - Session 5) 4

Moein Karami (FINA 410/AA - Summer 2021 - Session 5) 6

Cash flows can be measured to

Just Equity Investors

EBIT (1- tax rate) Net Income Dividends

Moein Karami (FINA 410/AA - Summer 2021 - Session 5) 7

üOperating income is revenue less any operating expenses, while net

Moein Karami (FINA 410/AA - Summer 2021 - Session 5) 9

Moein Karami (FINA 410/AA - Summer 2021 - Session 5) 10

Moein Karami (FINA 410/AA - Summer 2021 - Session 5) 11

Moein Karami (FINA 410/AA - Summer 2021 - Session 5) 12

• difference between the accounting and financial views of firms?

Moein Karami (FINA 410/AA - Summer 2021 - Session 5) 13

Moein Karami (FINA 410/AA - Summer 2021 - Session 5) 14

Moein Karami (FINA 410/AA - Summer 2021 - Session 5) 15

Moein Karami (FINA 410/AA - Summer 2021 - Session 5) 16

Moein Karami (FINA 410/AA - Summer 2021 - Session 5) 17

Normalize Cleanse operating items of

Moein Karami (FINA 410/AA - Summer 2021 - Session 5) 18

• Operating leases are considered a form of off-balance-sheet financing—meaning

• Historically, operating leases have enabled American firms to keep billions of

Moein Karami (FINA 410/AA - Summer 2021 - Session 5) 19

Moein Karami (FINA 410/AA - Summer 2021 - Session 5) 20

Moein Karami (FINA 410/AA - Summer 2021 - Session 5) 21

Moein Karami (FINA 410/AA - Summer 2021 - Session 5) 22

• Debt outstanding at The Gap = $1,970 m + $4,397 m = $6,367 m

Moein Karami (FINA 410/AA - Summer 2021 - Session 5) 23

Cost of capital = 8.20%(7350/9320) + 4% Cost of capital = 8.20%(7350/13717) + 4%

Moein Karami (FINA 410/AA - Summer 2021 - Session 5) 24

Moein Karami (FINA 410/AA - Summer 2021 - Session 5) 25

Moein Karami (FINA 410/AA - Summer 2021 - Session 5) 26

Current 1020.02 1.00

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• Don t take company characterizations of non-recurring charges at face

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• preferred dividends are ignored. If preferred stock exist, preferred dividends

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