To Finance: Financial Statements in Financial Analysis

Introduction
to Finance
by George Blazenko
All Rights Reserved © 2015, 2019
Chapter 2
Financial Statements in
Financial Analysis
“My problem lies in reconciling my gross habits with my net income.” Errol Flynn:
Australian-American actor (1909–1959)
“The average parent may, for example, plant an artist or fertilize a ballet dancer and end
up with a certified public accountant.” Ellen Goodman (b. 1941): U.S. journalist. “Goodman’s
Victory Garden,” Close to Home, Simon & Schuster (1979)
“It sounds extraordinary but it's a fact that balance sheets can make fascinating reading.”
Mary Archer. Read more at: https://www.brainyquote.com/quotes/mary_archer_197626 Dame
Mary Doreen Archer, DBE (née Weeden; born 22 December 1944), commonly known as
Mary Archer, is a British scientist specializing in solar power conversion.
“There's no business like show business…but there are several businesses like accounting.”
David Letterman (More from David Letterman on Accounting and Accountants)
“You can't connect the dots looking forward; you can only connect them looking
backwards. You have to trust that the dots connect to your future.” Steve Jobs
“There’s no accounting for the weather.” Professor Blazenko
In Chapter Two We Learn:
1. Financial-statement limitations for financial analysis?
2. Primary financial asset-holders of a firm?
3. Measure business expenditure (investment)?
4. Measure two business returns: the Rate of Return on
Invested Capital (ROIC, after-tax, after depreciation)
and the Rate of Return on Equity (ROE)?
5. Do ROIC and ROE relate to one another? Yes, they do!
6. Forecast ROIC with financial statement information
and financial market forecasts? Yes, we can!
7. Measure Free Cash Flow (FCF)?
8. FCF economic determinants?
9. Forecast FCF with forward ROIC and forward growth!
10. Calculate the business-investment opportunity cost rate
of return (the cost of capital) with forward ROIC,
forward growth, and asset market/book. (Yes, we can!)
11. Constant growth implied cost of capital limitations?
Yes, there are!
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Chapter Two Contents
(2.1) Introduction ..............................................................................................................3
(2.2) Recognize the Limitations of Financial Ratios .............................................................4
(2.3) A SPREADSHEET TEMPLATE FOR FINANCIAL ANALYSIS 7
(2.4) Measuring Business Expenditure with Invested Capital .............................................9
2.4.1 INVESTED CAPITAL (FINANCIAL) 9
2.4.2 INVESTED CAPITAL (OPERATING) 12
(2.5) Business Returns .....................................................................................................15
2.5.1 THE RATE OF RETURN ON INVESTED CAPITAL (ROIC) 17
2.5.2 THE RATE OF RETURN ON EQUITY (ROE) 20
2.5.3 THE RELATION BETWEEN ROIC AND ROE 22
2.5.4 WHY ARE ROIC AND ROE BOTH IRRS? 25
2.5.5 COMPONENTS OF BUSINESS RETURN 27
(2.6) Free Cash Flow ........................................................................................................31
2.6.1 THE OPERATING DEFINITION OF FREE CASH FLOW 33
2.6.2 THE FINANCIAL DEFINITION OF FREE CASH FLOW 36
2.6.3 AFTER TAX DISTRIBUTIONS TO CREDITORS 36
2.6.4 NET DISTRIBUTIONS TO SHAREHOLDERS 38
(2.7) The Cost of Capital
2.7.1 THE ECONOMIC DETERMINANTS OF FCF 38
2.7.2 MARKET/BOOK FOR ASSETS AND CONSTANT GROWTH 38
2.7.3 THE CONSTANT GROWTH COST OF CAPITAL 38
(2.8) Summary ….. ...............................................................................................................40
(2.9) Suggested Readings .....................................................................................................57
(2.10) Problems ......................................................................................................................58
(2.11) Chapter Index ..............................................................................................................85
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(2.1) Introduction
Next Section Table Contents
Financial accounting is the process of producing and disseminating information on the economic
activities of a firm. Many groups require information from financial statements, including
shareholders, creditors, employees, suppliers, government, and social interest groups. For at
least two reasons communication is weaker between professional accountants and financial
statement users than between other professionals and their clients (like, doctors and lawyers, for
example). First, accounting principles and the requirements of regulatory agencies tightly
constrain the content and format of financial statements (especially for publicly traded
corporations). They presume the information requirements of users without recognizing
differences in information needs. Second, users of financial statements have little opportunity to
make direct requests of accountants for individual treatment. They share general statements
despite diverse interests. Perhaps because of this diversity, accountants take pains to ensure
accuracy of financial statements but they provide little/no guidance on their use. In this chapter,
we study how investors use financial statements to analyze business and financial investments.
We integrate ratio calculations into financial analysis, which we know from Chapter 1 answers
four questions, including ― is this good business investment? This perspective has its origins in
the investment industry, which is that of financial analysts who use financial ratios/measures for
investment decisions.
In your financial accounting studies, you have undoubtedly calculated financial ratios from
financial statements. So, we will not calculate all possible financial ratios in this chapter. Rather,
we focus on measures/ratios most important to help answer the four questions of financial
analysis from chapter 1. Almost surely, many (most?) of the measures in the current chapter you
have not seen before. Remember that we are financial statement users rather than producers. To
help us ask and answer the questions of financial analysis we slice and dice and rearrange
financial statements in ways that might make a financial accountant cringe. However, our
purpose is to use financial statements for financial analysis, whatever that requires.
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(2.2) Recognize the Limitations of Financial Ratios
Next Section Previous Section Table Contents
Limitations of Ratios: 36 minutes
Before we begin financial analysis in earnest, you should be aware of financial statements/ratios
limitations for this purpose.
First, and possibly most importantly, there is no objective standard for most ratios. What
constitutes a high/low value is often a matter of business-judgment rather than business-theory.
Financial ratios measure business performance, efficiency, and risk. If used carefully, ratios can
be valuable tools to assess the financial health of a firm. However, for most ratios it is difficult
to determine whether the numeric-value is high, low, good, or bad. The reason for this ambiguity
is that the “theory of business” is not sufficiently strong to offer absolute standards (benchmarks)
for most ratios. (The theory of business is all of the business courses you study in a typical
business program.) Until we have a more complete theoretic picture, we often resort to relative
rather than absolute comparisons, like, trend analysis or industry averages. In trend analysis, we
determine whether a ratio is improving or deteriorating, not good or bad. In an industry
comparison, we determine whether a ratio is better or worse than the industry, not good or bad.
There is one exception to the general rule that the theory of business is not sufficiently strong to
give us absolute benchmarks. The exception is business returns and the theory of Finance, where
we benchmark returns against an opportunity cost rate of return from financial markets. This
opportunity cost rate of return is a number and, thus, an absolute standard. Beginning in this
chapter, we illustrate how, with a number of measures from financial markets, with some guiding
financial theory, and with some simplifying assumptions, we can calculate a firm’s cost of
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capital: the opportunity cost rate of return for business investment. By benchmarking business
return (of a particular type) with the cost of capital, we can answer the question of whether a firm
makes (or prospectively makes) “good” business investments for its financial asset-holders and
shareholders, specifically.
An example of an absolute standard for a business return is our first numerical example from
Chapter 1. A firm invests $300,000 today to generate (forecast) $400,000 in one year. Business
return is the IRR, which equals 33.3%. We said (without giving details) that the opportunity cost
rate of return from financial markets is 7%, which is an absolute standard with which we can
benchmark the 33.3% business return. Because the 33.3% is greater than the 7% we can say that
this is a “good” investment and creates wealth for financial asset-holders and shareholders in
particular. In this case, the theory of finance is sufficiently strong to give us an absolute
benchmark so that we can conclude that the business return is “good.”
We can benchmark any return, like, for example, those that we calculate in this chapter (the rate
of return on invested capital, ROIC, and the rate of return on equity, ROE) against financial
market opportunity cost rates of return. Alternatively, we could benchmark a firm’s ROIC or
ROE against industry averages or past values of these return ratios. But, an opportunity cost rate
of return is typically more informative for investors than a relative benchmark.
Industry comparison is a narrow perspective on corporate benchmarking. Remember that the

objective of a firm is to maximize shareholder wealth. You, as an employee of your firm, for
example, may be interested in how your firm performs relative to competitors. While
shareholders share this interest, they also have a broader perspective. Shareholders are restricted
neither to investing in any one firm, nor any one industry. Every firm competes globally for the
financial resources of dispassionate investors who choose to invest where they like in many
different firms and in many different industries. If your objective is to maximize shareholder
wealth, then you, like your shareholders, must adopt a broader perspective on corporate
performance than simple industry ratio comparison. To recognize a broader investor perspective,
we benchmark returns against financial market returns of about the same risk as the business
investment under study. This benchmark has a broader perspective because investors invest
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where they like in a broad range of different firms and industries to determine opportunity cost
rates of return.
Second, financial statements are historical but our theory of value (that is, NPV) has a future
(forward) orientation. We know from Chapter 1 that we determine whether an investment is
“good” based on whether NPV is positive or not. The NPV cash-flows that we discount are
predicted future cash flows (without giving the details). Financial statements recognize only
transactions that have taken place in the past. However, in this chapter, to help us answer the
question whether or not a firm makes “good” business investments for its financial asset-holders
and shareholders in particular, we use measures from financial markets along with financial
statements to help us forecast both business returns (ROIC and ROE) and cash-flows. In other
words, despite their historical orientation, we can use the structure of financial statements to help
us answer all financial-analysis questions.
Third, differences between firms' accounting methods limit the comparability of ratios.
Therefore, where there is a choice as to measure, seek to use ratios that are unaffected by
arbitrary accounting choices.
Fourth, different financial analysts calculate some ratios in different ways, even those that share
the same name: one can include/exclude different accounts and/or employ broader/narrower
interpretations. Because business theory is not generally strong enough to tell us exactly what to
measure and how, then naturally, different analysts calculate ratios in different ways.
In this book, we use discounted cash flow analysis (DCF) as our theory of value and financial
statements and financial market data as inputs to answer the questions of financial analysis. The
broad outline goes like this. Forecast prospective corporate business returns for all financial
asset-holders and shareholders in particular. Compare prospective business returns to objective
opportunity cost rates of return from financial markets. We need firm-specific information from
financial statements to help us forecast business returns and we need financial market measures
to calculate investor opportunity cost rates of return. Think of our numerical example from
Chapter 1 for guidance. In practice, we might use financial statement data to help us predict the
rate of return on business investment as 33% per annum. On the other hand, we use financial
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markets to help us determine that the opportunity cost for this business investment is 7% per
annum. Both components of this analysis are crucial to making an informed business decision.
Yes, things are complicated but in learning this perspective, you will understand more about
financial markets than most of the world’s population including many who claim to be financial
experts. It is my belief that with this perspective you will become a good “investor” for the
business investments of your firm and, also, a good financial investor/advisor. Without this
perspective, you will neither be a great business person nor a good financial-asset investor. So,
that is my challenge to you in reading this e-book and in your financial studies.
Despite the limitations above, benchmarking financial ratios, even with relative benchmarks, is
invaluable for business analysis. Suppose for example, that you forecast operating results for a
new business venture. If forecast financial ratios diverge far from industry or historic corporate
experience, then you have grounds to reconsider assumptions. This reflection imposes a
discipline on business planning.
(2.3) A Spreadsheet Template for Financial Analysis

The worksheet embedded below calculates all ratios we discuss in this chapter (and others) for
Telus (TELUS). TELUS is a national Canadian telecommunications company providing internet
access, entertainment, healthcare, video, and IPTV television. The company is based in greater
Vancouver (Burnaby). It is a public company with common shares traded on both the Toronto
Stock Exchange (TSX) and the New York Stock Exchange (NYSE).
Telus Corporation
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The TELUS workbook above serves as a template for financial analysis of other firms. Required
inputs are the income statement and the balance sheet. The spreadsheet then automatically
calculates each performance measure we develop in this chapter.
We retrieve TELUS financial statement data from a database called COMPUSTAT which is a
product of Standard and Poor’s Corporation (S&P). This database provides financial statement
information on over 10,000 publicly traded US and Canadian firms. S&P adjusts financial
statements to standardized accounting conventions and uses common line items for both income
statements and balance sheets for all companies, which enhances ratio comparability across
companies. Because of this line item standardization, we can cut and paste from one company to
another for financial analysis with the TELUS workbook above.
The graphical user interface for COMPUSTAT is called COMPUSTAT – CAPITAL IQ, which
is available to SFU students indirectly through the SFU library website via Wharton School of
Business (WRDS: Wharton Research Data Services). Use your SFU email user name with
@sfu.ca extension to identify yourself as an SFU student. The below video illustrates how to
access annual financial statement data going back many years for thousands of North American
(CAN and US) publicly traded companies. COMPUSTAT – IQ “TOOLS” allows you to
download complete financial statement data in an EXCEL spreadsheet. You can over-write the
data in the TELUS work-book above to automatically calculate the financial measures we study
in this chapter for any company that you might be interested in.
Financial Statements:
Compustat Capital - IQ
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(2.4) Invested Capital Measures Expenditure
Next Subsection Previous Section Table Contents
Returns are critically important in financial analysis. We are working toward calculating the
equivalent of the 33.3% business return from Chapter 1. If a firm invests $300,000 to generate
$400,000 in one year, the business return is 33.3% per annum. If we want a good return-measure,
we need a good expenditure measure, which is the equivalent of the $300,000. Expenditure is
one of the fundamental questions of financial analysis that we identify in Chapter 1. Financial
statements and a balance sheet in particular are not designed to answer the expenditure question.
So, in this section, we rearrange a balance sheet to calculate expenditure as Invested Capital,
which we can measure from either the corporate perspective (business investment) or from the
financial asset-holder perspective (shareholders and creditors as primary financial investors). So,
there are two calculations for invested capital: the financial and the operating. Even though the
operating calculation is more important for our financial analysis purposes, we begin with the
financial calculation because Invested Capital originates in the investment industry.
2.4.1 The Financial Definition of Invested Capital

Next Subsection Previous Subsection Table Contents
The total of all funds that have been invested by financial asset-holders in a firm is “invested
capital.” The term “invested” is used because these funds are associated with identifiable
financial assets sold by the firm. Invested capital is a measure of expenditure by financial asset-
holders rather than a measure of the value of these financial assets. All accounts on the financial
side of the accounting balance sheet that are associated with financial investing are included in
the calculation of invested capital. Invested capital is a commonly used measure in the
investment industry because it provides a good organizing framework for analysis. It helps to
separate the two sides of the “coin” which is the corporation, the operating and the financial side.
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Invested capital is a rearrangement of a firm’s accounting balance sheet to measure business and
financial-asset expenditure. The accounting balance sheet was never designed to answer the
expenditure question, which then necessitates the invested capital calculation. If we want a good
measure of business return – which we do – then, we need a good measure of expenditure.
Because an accounting balance sheet does not do this for us, we must rearrange it to measure
expenditure.
The following exhibit gives the accounting balance sheet for TELUS for a number of years. We
will shortly rearrange it to calculate invested capital.
Exhibit 2-1
Telus Corporation
(in millions of $US)
Fiscal Year: 2014 2015 2016 2017
(FYR Ending): (31DEC2014 ) (31DEC2015 ) (31DEC2016 ) (31DEC2017 )
ASSETS
Cash & Equivalents 60.000 223.000 432.000 509.000
Receivables - Total (Net) 1,580.000 1,429.000 1,480.000 1,719.000
Inventories – Total 320.000 360.000 318.000 378.000
Prepaid Expenses 199.000 213.000 233.000 260.000
Current Assets – Other 27.000 106.000 11.000 18.000
Current Assets – Total 2,186.000 2,331.000 2,474.000 2,884.000
Plant, Property & Equip (Gross) 30,938.000 31,626.000 32,906.000 33,599.000
Accumulated Depreciation 21,815.000 21,890.000 22,442.000 22,231.000
Plant, Property & Equip (Net) 9,123.000 9,736.000 10,464.000 11,368.000
Investments at Equity 39.000 28.000 51.000 62.000
Investments and Advances – Other 49.000 69.000 62.000 41.000
Intangibles 11,554.000 13,746.000 14,151.000 14,875.000
Deferred Charges .000 .000 62.000 57.000
Assets – Other 266.000 496.000 465.000 261.000
TOTAL ASSETS 23,217.000 26,406.000 27,729.000 29,548.000
LIABILITIES
Accounts Payable 458.000 476.000 578.000 717.000
Notes Payable 100.000 100.000 100.000 100.000
Accrued Expenses 1,439.000 1,456.000 1,697.000 1,677.000
Taxes Payable 2.000 108.000 37.000 34.000
Debt (Long-Term) Due In One Year 255.000 856.000 1,327.000 1,404.000
Other Current Liabilities 1,245.000 1,280.000 1,212.000 1,258.000
Total Current Liabilities 3,499.000 4,276.000 4,951.000 5,190.000
Long Term Debt 9,055.000 11,182.000 11,604.000 12,256.000
Deferred Taxes (Balance Sheet) 1,936.000 2,155.000 2,107.000 2,500.000
Investment Tax Credit .000 .000 .000 .000
Liabilities – Other 1,273.000 1,121.000 1,131.000 1,339.000
Noncontrolling Interest – Redeemable .000 .000 .000 .000
TOTAL LIABILITIES 15,763.000 18,734.000 19,793.000 21,285.000
SHAREHOLDERS' EQUITY
Preferred Stock .000 .000 .000 .000
Common Stock 5,175.000 5,050.000 5,029.000 5,205.000
Capital Surplus 141.000 135.000 372.000 370.000
Retained Earnings (Net Other) 2,138.000 2,487.000 2,516.000 2,646.000
Less: Treasury Stock .000 .000 .000 .000
Shareholders Equity – Parent 7,454.000 7,672.000 7,917.000 8,221.000
Noncontrolling Interest – Nonredeemable .000 .000 19.000 42.000
TOTAL SHAREHOLDERS EQUITY 7,454.000 7,672.000 7,936.000 8,263.000
TOTAL LIABILITIES AND EQUITY 23,217.000 26,406.000 27,729.000 29,548.000
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Exhibit 2-2 below calculates the financial definition of Invested Capital for TELUS for 2016.
The numbers come from the accounting balance sheet in Exhibit 2-1. You will see shortly why
we use 2016 rather than 2017.
Exhibit 2-2 tells us that at the end of 2016, the financial asset-holders of TELUS (creditors and
common shareholders) have invested over 24 billion dollars in TELUS financial assets (“ST” is
short-term and “LT” is long-term).
Exhibit 2-2
Financial Definition of Invested Capital: TELUS 2016
(in $US millions)
Notes Payable plus other ST Debt plus
Current Portion of LT Debt $100 + $1,327
LT Debt and other LT Liabilities $11,604 + $1,131

Preferred Shares 0
Deferred Income Taxes $2,107
Total Shareholder Equity $7,936
Other Financial Assets 0
Invested Capital in the Financial

$24,186
Calculation
To summarize financial expenditure (invested capital) even further than Exhibit 2-2, let us define
“debt” as short-term debt plus long-term debt plus other long-term liabilities. Thus, at year-end
2016, TELUS’s debt is $100 + $1,327 + $11,604 + $1,131 = $14,162. Let us define “Equity”
(that is, book equity) as the sum of Total Shareholder Equity1 plus Deferred Income Taxes.2 At
1
Less “Non-Controlling Interest – Non-Redeemable.”
2
The principal reason for the existence of deferred income taxes is a difference between depreciation for financial
reporting and for income tax purposes. Generally, governments are generous in tax deductions for depreciation. So
depreciation for income tax purposes often exceeds depreciation for financial reporting. If depreciation for reporting
2-11
the end of 2016, TELUS’s equity is $7,917 +2,107 = $10,024. Note carefully that these are
expenditure calculations. The value of TELUS financial assets may have increased or decreased
since the original investment by financial asset-holders: Invested Capital is an expenditure
calculation and not a value calculation.
At year-end 2016, TELUS’s Invested Capital in the financial calculation is the sum of debt and
equity: $14,162 + $10,024 = $24,186. You can see these numbers in the column for 2016 in
Exhibit 2-3 below.
2.4.2 The Operating Definition of Invested Capital

If invested capital in the financial calculation measures the amount that financial asset-holders
have invested in the financial assets of a firm, then the other side of the coin (the corporation)
measures business investment by the corporation for the benefit of all financial asset-holders
(generally creditors and common shareholders). This is the operating definition of invested
capital.
Firms make two general types of business investments. First, firms invest in what might be
termed their “trading” function. Firms make trades associated with the two components of the
income statement, revenues and expenses. Sales represent trades that firms make with their
customers. Expenses represent trades that the firm makes with their suppliers, employees,
landlords, and the government. Firms must make an investment into short-term assets in order to
support this trading function. For example, accounts receivable are held to support credit sales.
Inventories are held to ensure that sales can take place when requested by customers. Some of
represents the economics of the situation (possibly accountants’ best forecast of maintenance capital expenditure to
offset economic depreciation), then governments routinely give businesses a tax subsidy for depreciation (possibly
to encourage depreciable asset investment). This tax subsidy accumulates on the balance sheet as deferred income
tax (DIT). Since tax-subsidies accrue mainly to shareholders, financial analysts often treat DIT as an “equity” for
the purpose of financial analysis even though it commonly appears in the liability section of an accounting balance
sheet. For stylized companies in end-of-chapter problems, quizzes, midterms, and finals (associated with
study/reference materials), we presume that depreciation for tax and financial statement purposes is the same and,
thus, there is no deferred income tax in those questions.
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these short-term investments can be financed with deferred payments associated with trades that
the firm makes with product and service suppliers. These deferred payments are measured on
the accounting balance sheet as, for example, “accounts payable,” “wages payable,” and
“income taxes payable.” Income taxes payable can be thought of as a deferred payment for the
infrastructure services provided by the government. The net amount which firms must hold to
support the trading function associated with their operations is referred to as “trade capital.”
Sometimes, companies have such great economic power over their supplies that they can defer
payments to suppliers for inordinate periods of time with the result that trade capital can be
negative. We will see shortly that this is often the case for TELUS.
Trade capital equals current assets minus current liabilities on the balance sheet but excluding
from current liabilities those accounts that are purely financial in nature. The excluded accounts
are related to financial asset investing and are not operational in nature (that is, they exist for
financial investors to earn a rate of return, which is not the case, for example, for accounts
payable). Accounts that reasonably can be excluded are dividends payable, short-term debt, and
the current portion of long-term debt.
Trade capital is similar to net working capital. Net working capital is current assets less current
liabilities. The difference between trade capital and net working capital is that trade capital
excludes any current liability that is financial and exists because an investor is looking to earn a
rate of return. For 2016, we calculate Telus’s Trade Capital as all of their Current Assets less
Accounts Payable less Accrued Expenses less Taxes Payable less other current liabilities:3 TC16
= $2,474-$578-$1,697-$37-$1,212 = -$1,050. Trade capital is not often negative but it is
possible. Negative trade capital means that a firm’s suppliers are helping finance (pay for) their
business investments (in part). Exhibit 2-3 below gives this number as part of Invested Capital
for TELUS in the operating calculation for year-end 2016.
The second business investment that firms make is net fixed assets (plus other long-term
business investments). This investment is required to support the long-term production and
3
We do not know what “other current liabilities” are, but because they are short-term, they are more likely to be
operating than financial.
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commercial activities of the firm. Net Fixed Assets (NFA) equal the cost basis of fixed assets,
net of accumulated depreciation. For TELUS we measure long term business investment as
Plant, Property, and Equipment (Net of Accumulated Depreciation) plus Other Long Term
Assets4 (including, Investments at Equity, Investments and Advances, Intangibles, Deferred
Charges and Other Assets). So, for year-end 2016 for TELUS their long-term business
investments equal: $10,464+$51+$62+$14,151+$62+$465-$19 = $25,236.
The sum of trade capital and net fixed assets (and other long-term assets) equals invested capital.
In the table below, Invested Capital for TELUS at year-end 2016 is: IC16 = -$1,050+$25,236 =
$24,186. So, at year-end 2016, the total business investment of TELUS, short-term and long-
term, is over 24 billion dollars.
2.4.3 The Invested Capital Balance Sheet
Next Section Previous Subsection Table Contents
The amount financial asset-holders have invested in a firm’s financial assets must equal the equal
the firm’s business investments. The below Invested Capital Balance Sheet, summarizes
financial asset-holder investments (ICfin) and business investment (ICop). These investments
equal one another for each year 2010-2017. Our invested capital balance sheet balances!
4
Net of “Non-Controlling Interest Non-Redeemable.”
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Exhibit 2-3
Invested Capital: TELUS
($US millions, other than rates)
2010 2011 2012 2013 2014 2015 2016 2017
Trade Capital (TC) -1,816 -324 -363 -570 -958 -989 -1,050 -802
Net Fixed Assets + other (NFA) 18,187 17,880 18,235 19,237 21,031 24,075 25,236 26,622
Invested Capital (Operating) 16,371 17,556 17,872 18,667 20,073 23,086 24,186 25,820
Debt 6,694 8,443 8,562 8,761 10,683 13,259 14,162 15,099

Equity 9,677 9,113 9,310 9,906 9,390 9,827 10,024 10,721
Invested Capital (Financial) 16,371 17,556 17,872 18,667 20,073 23,086 24,186 25,820
Effective Tax Rate 0.240 0.236 0.257 0.268 0.260 0.275 0.256 0.272
EBITDA (+other) 3,564 3,771 3,995 3,951 4,206 4,321 4,263 4,780
ROIC (BOP) 0.092 0.090 0.088 0.094 0.087 0.071 0.078

ROE (BOP) 0.126 0.145 0.139 0.144 0.147 0.123 0.144
Effective interest rate 0.051 0.041 0.043 0.045 0.042 0.040 0.039
after tax interest rate on debt 0.039 0.031 0.031 0.033 0.030 0.029 0.028
In Exhibit 2-3, we calculate the “Effective interest rate” as Interest from a income statement year
in Exhibit 2-4 (below) divided by average debt: debt at year-beginning plus debt at year-end
divided by two. We use average debt because an interest rate calculation is sensitive to debt-
balance changes over a year. For example, there is a large debt balance increase for TELUS from
2013 to 2014 (almost 3 $US billion). If we calculate TELUS’s interest rate based on the year-
beginning balance, then we overstate the interest rate because we miss the increase in debt-
principal over 2014 that generates some of 2014 Interest.
(2.5) Business Returns

We design and calculate the invested capital balance sheet above because we need a good
expenditure measure for a good business-return measure. Returns are critically important in
financial analysis. In our first numerical example of this book, a firm invests $300,000 to
generate $400,000 in one year. If the opportunity cost rate of return from financial markets is 7%
per annum, the NPV (wealth creation) for financial asset-holders and shareholders in particular is
$73,832. Because this number exceeds zero, we conclude in chapter 1 that this is a “good”
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business investment and should be undertaken by the firm. However, it is hard to assess, without
further analysis, whether this amount is exceptionally good or only marginally good. Because we
all have a basic understanding of what constitutes a good or a bad rate of return from financial
markets (in fact, the 7% in the above example give us this understanding), if we can calculate
business returns then we can assess whether this investment is exceptionally good or only
marginally good.
There are two principal business returns and, further, they relate to each other. The first is the
rate of return that a firm earns on its business investments: the rate of return on invested capital
(ROIC), which we typically calculate after depreciation and after tax. In addition, because
financial asset-holders finance business investments, we sometimes referred to this return as the
rate of return that a firm earns for all financial asset-holders (generally, creditors and common
shareholders).
Second, we have a special interest in shareholders because of our presumption that the primary
objective of managers in operating a business is to maximize shareholders’ wealth. So, our
second business-return measures the return a business earns for shareholders, specifically. We
call this business-return the rate of return on equity (ROE). In the following sections, we
investigate these two business returns and how they relate to one another. This relation means
that one business return is a relative benchmark for the other and vice versa. We also answer the
question why both ROIC and ROE are IRRs.
The principal determinants of business returns and opportunity cost rates of return are very
different. The determinants of opportunity cost rates of return are interest rates in the economy
and risk because investors determine opportunity cost rates in financial-market trading/investing
and their primary concerns are interest rates and risk. On the other hand, business investments do
not generally trade in organized markets and, thus, investors typically have no occasion to
influence their values. The principal determinant of business returns (both ROIC and ROE) is
corporate profitability. Don’t confuse business returns with opportunity cost rates of return.
2-16
2.5.1 The Rate of Return on Invested Capital (ROIC)
The rate of return on invested capital is the rate of return on a firm’s business investments for all
financial asset-holders. It is not a rate of return on market-value (like a share price, for example)
but a rate of return on expended funds (expenditure):
(1−𝑡)∗(𝐸𝐵𝐼𝑇𝐷𝐴+ 𝑜𝑡ℎ𝑒𝑟 𝑖𝑛𝑐𝑜𝑚𝑒 − 𝑑𝑒𝑝𝑟𝑒𝑐)

ROIC( after- tax and after depreciation) =
𝐼𝐶𝐵𝑂𝑃
where “t” is the corporate tax rate and “deprec” is depreciation. EBITDA is earnings before
interest, tax, depreciation, and amortization.
ROIC recognizes not only forecast replacement of deteriorating assets (with depreciation) but
also taxes arising from business investment and deductibility of depreciation for tax. In ROIC,
you may or may not include “other income,” depending upon your preference as a financial
analyst but I tend to include it because ROE invariably includes it. So, consistency requires its
inclusion in ROIC. To calculate ROIC, we need several measures off the income statement,
which we report for TELUS for a number of years in Exhibit 2-4 below.
BOP in ROIC (above) stands for “beginning of period.” Financial analysts don’t always use
BOP. Sometimes they use EOP (end of period) or even average investment, (BOP+EOP)/2.
While it is not always appropriate, my preference is for BOP because it is more natural for a
return calculation. In any return, we need expenditure at the beginning of a period and that
generates a return over the course of that period. For example, below, TELUS’s business
investment at the beginning of 2017 (end of 2016) was $24,186. Over the course of 2017, they
earn EBITDA after depreciation and after tax.
In the financial calculation, EBITDA (earnings before interest, tax, depreciation, and
amortization) is SALES less Cost of Goods Sold less General and Administrative Expenses
(G&A). TELUS does not report G&A separately from Cost of Goods Sold. So, for TELUS for
2017, EBITDA is the same as GROSS PROFIT = $4,805. 2017 depreciation is $2,182. Other
2-17
Income and Special Items are $88 - $113 = -$25. The “effective” tax rate from the income
statement in Exhibit 2-4 is Income Tax Expense divided by Income before Tax. For TELUS for
2017 their effective tax rate is 27.2%. Since year-beginning for 2017 is year-end for 2016, we
measure ICBOP with IC16 from the invested capital balance sheet in Exhibit 2-3: $24,186.
So, TELUS’s ROIC after-tax and after depreciation for 2017 with year-beginning IC is,
ROIC17 = (4,805−25−2,182)∗(1−0.272)
24,186
= 7.82%
You can see this 2017 calculation and for a number of earlier years summarized in Exhibit 2-3. A
simple trend analysis tells us that TELUS’s ROIC17 is lower than earlier in this decade. However,
we do not know whether this rate is high or low until we do some benchmarking with financial
market opportunity cost rates of return.
2-18
Exhibit 2-4
Telus Income Statement
INCOME STATEMENT
Fiscal Year: 2014 2015 2016 2017
(FYR Ending): (31DEC2014 ) (31DEC2015 ) (31DEC2016 ) (31DEC2017 )
Sales (Net) 11,927.000 12,430.000 12,725.000 13,202.000

Cost of Goods Sold 7,714.000 8,041.000 8,097.000 8,397.000
Gross Profit 4,213.000 4,389.000 4,628.000 4,805.000
Selling, General, & Admin Expenses
Operating Income Before Depreciation 4,213.000 4,389.000 4,628.000 4,805.000
Depreciation, Depletion, & Amortiz 1,842.000 1,912.000 2,059.000 2,182.000
Operating Income After Depreciation 2,371.000 2,477.000 2,569.000 2,623.000
Interest Expense 438.000 503.000 542.000 566.000
Non-Operating Income/Expense 81.000 167.000 99.000 88.000
Special Items -88.000 -235.000 -464.000 -113.000
Pretax Income 1,926.000 1,906.000 1,662.000 2,032.000
Income Taxes – Total 501.000 524.000 426.000 553.000
Minority Interest .000 .000 13.000 19.000
Income Before EI&DO 1,425.000 1,382.000 1,223.000 1,460.000
Extraordinary Items .000 .000 .000 .000
Discontinued Operations .000 .000 .000 .000
Net Income (Loss) 1,425.000 1,382.000 1,223.000 1,460.000
Income Before EI&DO 1,425.000 1,382.000 1,223.000 1,460.000
Preferred Dividends .000 .000 .000 .000
Available for Common Before EI&DO 1,425.000 1,382.000 1,223.000 1,460.000
Common Stock Equivalents – Savings .000 .000 .000 .000
Adjusted Available for Common 1,425.000 1,382.000 1,223.000 1,460.000
STATEMENT OF RETAINED EARNINGS

Fiscal Year: 2014 2015 2016 2017
Cash Dividends 913.000 992.000 1,070.000 1,082.000
2.5.2 Industry ROIC
If you wish to benchmark a business by its industry, industry-ROIC will be of interest to you.
The chart below plots average realized ROIC after tax and after depreciation (from 2000 to
2016) for 360 US and Canadian industries. ROIC for individual industries is in the spreadsheet
that follows the chart. The lowest average industry-ROIC is about -30% and the highest is about
30%. The mean average industry ROIC is 5.2%.
2-19
ROIC Frequency for 360 Industries (2000 to 2016)
120
100
80
60
40
20
0
-0.300 -0.200 -0.100 0.000 0.100 0.200 0.300
ROIC After Tax and After Depreciation for

360 US and Canadian Industries
2.5.3 The Rate of Return on Equity (ROE)

ROE: 7 Minutes
If the primary objective of managers is to maximize shareholders’ wealth, then an important

corporate performance measure is business return for shareholders; the rate of return on equity
(ROE) equals net income divided by “book equity.”
2-20
Net Income available to common
ROE =
Book Equity (b.o.p.)
From Exhibit 2-4, net income for 2017 for TELUS is $1,4415 and book equity in our Invested
Capital balance sheet in Exhibit 2-3 above for 2016 is $10,024. Thus, 2017 ROE for TELUS is,
1,441
ROE = 10,024 = 14.4%
We have three observations about this return. First, like our discussion above for ROIC we do
not know immediately whether 14.4% is high or low. However, because ROE is a return,
ultimately, we can benchmark it with an absolute standard: a financial market opportunity cost.
Second, notice that ROE17 = 14.4% > ROIC17 = 7.82%. There are two primary reasons why
ROE>ROIC. We identify these reasons in end-of-chapter question #5.
Third, ROE and ROIC are relative benchmarks for one another. When one is high, they are both
high and, then, ROE>ROIC. When one is low, they are both low and, then, ROE<ROIC. These
statements indicate that ROIC and ROE are related to one another. The reason they are related is
the primary determinant of both is corporate profitability. So, if you find ROE>ROIC, then it
has been a relative good year for corporate profitability and vice-versa. We investigate the
relation between ROIC and ROE more formally in the next subsection.
The chart below plots the frequency of average realized ROE (from 2000 to 2016) for 360 US
and Canadian industries. ROE for individual industries is in the spreadsheet that follows the
chart. The lowest average industry ROIC is about -32% and the highest is about 126%. The
average industry-ROE is 9.2%.
5
Net of “Minority Interest.”
2-21
Frequency of Average ROE for 360 US and
Canadian Industries (2000 - 2016)
60
50
40
30
20
10
0
-0.400 -0.300 -0.200 -0.100 0.000 0.100 0.200 0.300 0.400
ROE for 360 US and Canadian Industries
2.5.4 The Relation Between ROIC and ROE

The Relation Between ROIC and ROE: 19 Minutes
ROE and ROIC move in tandem with one another. That is, if ROIC is great, then ROE is great
as well. Remember that the primary determinant of either is corporate profitability. So, if
corporate profitability is high, then both are high.
2-22
The following equation gives the relation between ROIC (after tax/after depreciation) and ROE,
Debt BVE
ROIC  (1  t )* rD *  ROE * (2.1)
IC IC
where t is the corporate tax rate, rD is the interest rate that a firm pays on its debt, Debt is debt
outstanding on the invested capital balance sheet, BVE is the book value of equity on the
invested capital balance sheet, and IC is invested capital.
In business analysis, the “short-term” is generally up to one year hence. In the above relation, we
presume that most corporate characteristics are constant in the short-term (that is, rD , t, and
Debt / IC ). However, in business analysis we cannot assume SALES to be constant in the short-
term or long-term. Since corporate profitability depends upon SALES and business returns
depend upon corporate profitability, we cannot presume ROIC or ROE to be constant in either
the short-term or long-term. Rather, ROE and ROIC move in tandem with one another according
to the above relation. When one is great the other is great and vice versa.
For chapter-end problem #39, you calculate ROIC in two ways. First, as
(EBITDA−deprec)∗(1−t)
𝑅𝑂𝐼𝐶 = , (2.2)
𝐼𝐶
and, second, as the right of,
Debt BVE
𝑅𝑂𝐼𝐶 = (1  t )* rD *  ROE * .
IC IC
Of course, if you do the question correctly, the two methods give you the same value. As we
will see in this chapter, having two different ways to calculate the same thing is sometimes
invaluable in financial analysis. If there is a problem with one methodology, then the other might
work for us. We will encounter this case for McDonalds below.
2-23
Depending upon corporate profitability in any particular year, sometimes ROIC>ROE and
sometimes ROIC<ROE. So, it is possible in a particular time period (although not likely) that
ROIC and ROE exactly equal one another. In this case, set ROIC=ROE in the above formula and
Debt BVE
do a little algebra. In particular, because  1 (that is, Debt+BVE=IC),
IC IC
ROIC  ROE  (1  t )* rD . This result represents a financial break-even for shareholders with
respect to debt use. If a firm makes business investments at the same rate that it borrows (after
corporate tax), then ROIC and ROE equal one another and both equal the after-tax interest rate
on debt. Thus, we can make the following statement. Profitability for a business in a particular
year is relatively good if ROIC exceeds the after tax cost interest rate on debt and, in addition, in
this case, ROE exceeds ROIC. The vice versa is also true. Profitability for a business in a
particular year is relatively bad if ROIC is below the after tax cost interest rate on debt and, in
addition, ROIC exceeds ROE. We can also say that if ROE>ROIC, then corporate profitability is
relatively good for that firm in that year.
Notice in Exhibit 2-3 for TELUS, both ROIC and ROE exceed the after-tax interest rate on debt
for each of the years 2011-2017. Thus, in each of these years ROE exceeds ROIC, as well.
End of chapter problems give numerous opportunities for you to test your understanding of the
above relation between ROIC, ROE, and other financial variables.
Don’t make the mistake of concluding from our discussion that if a firm makes business
investments at a return above the after-tax interest rate on its debt that debt-financing for
business investments is preferable for shareholder wealth maximization compared to equity
financing. That conclusion is unjustified for reasons not immediately obvious. You need to take
advanced finance courses if you want to study questions of that nature in detail. Also, recognize
that ROIC and ROE are relative and not absolute benchmarks for one another. If a firm makes
business investments at a return above the after-tax interest rate on its debt, these business
investments do not necessarily create wealth for financial asset holders and shareholders
specifically. The after-tax interest rate on debt is not risk-adjusted so that it does not allow for an
“apples to apples and oranges to oranges” comparison with respect to risk for business
investments versus financial asset investing.
2-24
There are some timing issues that are important in the above relation between ROIC and ROE. If
a firm borrows incrementally or repays principal at year-end, then Debt, BVE, and IC must be
beginning-of-period (BOP) in the above relation. If a firm borrows incrementally or repays
principal at beginning of year, then Debt, BVE, and IC must be end of year (EOP). Last, if a firm
borrows incrementally or repays principal exactly at mid-year, then Debt, BVE, and IC must be
BOP plus EOP divided by two (that is, average expenditure). The reason for these slight
differences in the above relation is that $INTEREST that a firm pays during a year depends upon
whether they borrow incrementally (or repay) BOP, EOP, or mid-year.
2.5.5 Why are ROIC and ROE both IRRs?

I have a confession to make. The numerical example that we present in chapter 1, a firm invests
$300,000 to generate $400,000 in one year, is not a typical business investment. Most business
investments have no predefined termination or maturity date. I think we should focus on typical
rather than atypical things. But be careful, sometimes business investment can be atypical!
Let’s consider a typical business investment that has no predefined termination. Suppose a
business plans an investment for which the required expenditure today (that is, the investment) is
$I. The “benefit” of this business investment is cash flow of $c per annum indefinitely starting in
one year (free cash flow in the upcoming section). The opportunity cost rate of return from
financial markets for financial investments of about the same risk as this business investment is
r% per annum (the cost of capital).
For this typical business investment, NPV is,
c
NPV  PV  I  I
r
2-25
Net Present Value (NPV) is always Present Value (PV) less expenditure (I). Notice in PV above,
we divide by “r” rather than “1+r.” In the numerical example of chapter 1, for a similar term, we
divided by “1+r,” so what is the difference?
The “one” in “1+r” indicates we (as the business investor) want one dollar back (in one period,
typically one year) per one dollar of business investment. Plus, we want (really we want for
shareholders) compensation for time (one year) and risk. The opportunity cost rate of return “r”
embeds a financial market compensation for time and risk. So, rather, when we divide by “r” in
PV above, we are anticipating (it might not always be true) that this is a “good” business
investment (NPV>0) and we will commence the business investment today. Now, if this is a
good business investment today and if the business environment does not unduly deteriorate in a
year or the following year or the following year, etc., then, this will always be a good business
investment and, thus, we never want to terminate it. If we anticipate never wanting to terminate
this business investment, we never want the dollar of original business investment back.
Terminating the business destroys what we believe to be a “good” business investment. Thus, in
the PV above, we divide by “r” rather than “1+r.” We want compensation for time and risk for
our shareholders but we never want back the dollars of original business investment.
If we never get capital back (original business investment), how can our business have value?
After the business investment the value of the business has nothing to do with capital but,
alternatively, with future cash-flow that that capital generates. Remember that our theory of
value is future (forward) not past oriented. The value of the business after the business
investment is PV=c/r and expenditure on business capital (I) does not appear in this calculation.
We could prove these statements mathematically (I don’t think you want me to do this) but this
is the business-explanation of PV above.
Any IRR is the “hypothetical” opportunity cost rate of return that makes NPV equal zero. So, for
a typical business investment, we find the IRR from,
c
NPV  I 0
IRR
Solve this equation to find that the IRR for a typical business investment is,
2-26
c
IRR 
I
Notice that in the first year of our business investment, expenditure = $I, is at the beginning of
the year and the cash flow $c is at year-end for all years including the first. So, that is why my
preference is for using BOP (beginning of period) for business returns like, ROIC and ROE,
above. IRR for a typical business investment presumes year-beginning expenditure.
So, now we can investigate why ROIC and ROE are both IRRs.
For ROIC, c = (EBITDA-deprec)*(1-t) and I = IC, and, thus, ROIC is an IRR. Similarly, for
ROE, c = NI (net income) and I = BVE (book value of equity) and, thus, ROE is also an IRR.
Both ROIC and ROE are special cases of IRRs.
When we use ROIC and ROE as business returns, not only are they IRRs, but they also presume
the pattern of cash-flows we describe above: the business investment ($I today) generates $c per
annum indefinitely starting in one year. Notice that this cash-flow pattern has no growth
expectation. Thus, we presume no-growth for a typical business investment. This does not mean
that businesses do not grow. Of course, they do (generally) as they make incremental expansion
investments none of which we expect to grow individually. Further, not all business investments
are typical. In chapter 6, we learn how to calculate the return on a business investment regardless
of the pattern its forecast future cash-flows might take.
2.5.6 Components of ROIC

EBITDA Margin: 18 Minutes
2-27
Gross profit less selling, general, and administrative expenses (before depreciation and
amortization) equals earnings before interest, tax, depreciation and amortization which is often
abbreviated as EBITDA6. EBITDA measures profitability of a firm's operations, net of both
production and commercial expenses. Financial analysts calculate net operating margin (also
referred to as the EBITDA margin) as EBITDA divided by sales.
EBITDA $4,805
EBITDA Margin  = $13,202 = 36.4%
Sales
for TELUS in 2017.
The EBITDA margin is a measure of operating efficiency. It measures the fraction of $1 of

sales, which goes to the “bottom” line after production and commercial expenses (that is, to
EBITDA). In later chapters, we will see that the EBITDA margin is also a measure of
“operating risk.”
The spreadsheet below calculates the EBITDA margin for 309 US and Canadian industries for
2016 (data is from the COMPUSTAT database).
Industry EBITDA Margins for 2016
The average EBITDA margin over industries is about 12.7%. This value is useful for
benchmarking US and Canadian firms with respect to operating efficiency and operating risk.
The below chart plots the relative frequencies of the EBITDA margin by industry. Notice that
most EBITDA margins are positive, but some are negative, and some are exceptional high near
100%.
6
EBITDA is also typically calculated before the line items “other income” and “extraordinary income” (or loss).
Each of these amounts is either non-recurring or outside the firm’s normal business practice. Therefore, EBITDA as
described in the text above is sometimes referred to as “EBITDA from core operations.” For simplicity, unless
otherwise stated in this book, when we use the term “EBITDA,” we really mean EBITDA from core operations.
2-28
Relative Frequencies of EBITDA Margin for 309
Industries
0.1
0.08
0.06
0.04
0.02
0
-0.2 0 0.2 0.4 0.6 0.8 1
What question of financial analysis are we investigating with the EBITDA margin? The answer
is the EBITDA margin is a component of return; it is not a return itself. However, when
multiplied by the invested-capital turnover ratio, you get ROIC before tax and before
depreciation and, of course, business returns are very important in financial analysis.
IC Turnover: 7 ½ Minutes
Invested capital turnover is a measure of the ability of a business to generate sales from business
investment. Other things equal, firms that can increase sales without an increase in invested
capital are more efficient. Below we calculate invested-capital turnover7 as sales for the period
divided by invested capital (b.o.p.),
7
Rather than invested capital turnover, accountants tend to use asset-turnover, which is yearly sales divided by the
book-value of all of a firm’s assets.
2-29
Sales
Invested Capital Turnover =
Invested Capital (b.o.p.)
The 2017 invested capital turnover ratio for TELUS is $13,202/24,186=0.546.
Invested capital turnover is an inverse measure of “capital intensity.” Firms that require great
business investments to generate a dollar of sales are said to be capital intense. Firms that
require large fixed asset investment, which often have payoffs over many years (for example,
utilities), have low invested-capital turnover. While firms have some influence over their
invested-capital turnovers (for example, revenues depend upon product pricing), the example of
utilities highlights the fact that invested capital turnover is, in large part, based on the technology
of the industry in which a firm operates.
For US and Canadian firms, the average and median invested-capital turnover ratio across 432
industries is 1.45 and 1.04, respectively (from 2000 to 2016). See the below spreadsheet for IC-
turnover ratios for individual industries.
IC-Turnover for 432 US and Canadian Industries 2000 to 2016
Using the definitions of EBITDA margin and invested capital turnover, you can illustrate that the
rate of return on invested capital before depreciation and before tax is the product of the
EBITDA margin and invested capital turnover.
ROIC = EBITDA Margin  Invested Capital Turnover
EBITDA Sales
ROIC = 
Sales Invested Capital (b.o.p.)
EBITDA
ROIC =
Invested Capital (b.o.p.)
2-30
ROIC Components: 10 Minutes
EBITDA margin and invested capital turnover are related to each other. Industries with low
invested capital turnover tend to have high EBITDA margins and vice-vera.
Why does there exist an inverse relationship between invested capital turnover and the EBITDA
margin? Firms with low invested-capital turnover are capital intense and have large depreciable
asset investments, like, for example, the locomotives, box-cars, and rails of TELUS. These large
depreciable-asset investments are an entry barrier for potential competitors. Thus, capital intense
business face relatively less competition and consequently their EBITDA margins tend to be
higher than those of less capital intense businesses. So, even capital intense businesses that make
long-term depreciable asset investments and have modest SALES per dollar of business
investment (IC) can earn an adequate rate of return (ROIC) for their financial asset-holders.
(2.6) Free Cash Flow

Next Subsection Previous Subsection Table Contenst
FCF: 3 Minutes
Cash flow is the lifeblood of any firm. Firms with abundant cash flow thrive and grow; firms
strangled by insufficient cash flow wither and die. Even short periods of inadequate cash flow
2-31
have traumatic effects on firms and their employees. It is critically important, therefore, that you
be able to trace and evaluate the flow of cash through your firm. Cash flow is investigated in this
subsection using the concept of free cash flow. Free cash flow (FCF) plays a very important role
in financial analysis. In later chapters of this book, predicted future free cash flow is the
foundation of corporate valuation, the method we use for setting the value of a firm’s assets in
place. Likewise, predicted incremental free cash flow from a new business venture is central to
the evaluation of prospective business investments that we analyze in chapter 9. Because of
these important uses of free cash flow, it is essential to develop this concept early in our study of
corporate financial analysis.
c
For a typical business investment (see above), NPV   I . In this equation, “c” is FCF. So,
r
FCF (generally in the operating calculation below) is what we discount in NPV analysis as
financial analysts to establish the value to shareholders of business investments. Since FCF is
paid out to financial asset holders (the financial calculation of FCF below), it is the source of
value of all the financial assets of a business for creditors and shareholders.
Let us begin with a casual and intuitive description of free cash flow. Free cash flow is the net
amount of cash that flows into a firm as the result of operations. Inflows arise from past business
investments. In the current period, the firm bears the “fruit” of past investment. In addition, the
firm might make additional business investments. These investments are composed of both short
and long-term business investments. The difference between these two cash flows (the first is
typically an inflow and the second is typically an outflow) is free cash flow. The adjective “free”
refers to the fact that this net cash flow is available (i.e., free) and is distributed in one way or the
other to financial asset holders. This relationship between cash flow arising from operations and
distributions to financial asset holders implies that there is both a financial and an operating
definition of free cash flow.
2-32
2.6.1 The Operating Definition of Free Cash Flow
FCFOP: 28 Minutes
We can calculate Free Cash Flow (FCF) as Funds From Operations (FFO) less incremental
investment:
Free Cash Flow = FFO - Incremental Investment
FFO is the “benefit” of past business investment.
FFO (bottom up)8 = Net Income + Depreciation + other non-cash charges +After-Tax Interest
FFO = 1,460 +2,182+566*(1-0.272) = $4,054 (in $US millions)
(2017 net income is $1,460, deprec is $2,182, dollar interest is $566, effective tax rate is 27.2%).
Now, let’s calculate incremental business investment for 2017 for TELUS. We know from our
discussion of invested capital that businesses make two primary business investments. The short-
term investment is Trade Capital (TC) and the long-term business investment is Net Fixed Assets
(NFA). Incremental business investment for a period is incremental trade capital plus
incremental depreciable asset investment (plus other long-term business investments) that we
measure as Capital Expenditure (CAPX).
8
“Bottom up” means begin with “net income” and then work your way to the top of the income statement by adding
back non-cash charges and after-tax interest. The “Top Down” FFO calculation, alternatively, (ignoring other
income) is FFO=(1-t)*(EBITDA-deprec)+deprec, presuming depreciation for reporting and for tax purposes is the
same.
2-33
The IC balance sheet in above (Exhibit 2-3) has Trade Capital as a component. The symbol Δ
represents change over a period (end of period EOP minus beginning of period BOP).
∆𝑇𝐶 = 𝑇𝐶𝐸𝑂𝑃 − 𝑇𝐶𝐵𝑂𝑃 = 𝑇𝐶17 − 𝑇𝐶16=-802-(-1,050)=$248 ($US millions)
Incremental short-term business investment for TELUS in 2017 is $248.
We can rearrange an accounting calculation to determine CAPX.
NFAEOP  NFABOP  CAPX  deprec .
So,
CAPX  NFA  deprec
The IC balance sheet above has NFA (plus other long-term investments) for TELUS. In addition,
depreciation for 2017 for TELUS is $661. So, for TELUS for 2017,
𝐶𝐴𝑃𝑋17 =26,622-25,236+2,182 = $3,568 ($US millions)
So, let’s put this all together. FCF (operating) is FFO less incremental business investment:
FCF  FFO  TC  CAPX
For TELUS for 2017,
𝐹𝐶𝐹17 = $4,054 - $248 - $3,568 = $238 ($US millions)
2-34
Because this amount is positive, TELUS has a Free Cash Flow surplus. On the other hand, firms
that have negative FCF have a Free Cash Flow deficit. Zero is a benchmark for FCF. However,
for any firm at any time, positive or negative FCF is not necessarily good or bad. An
investigation of why a firm has negative or positive FCF might lead to a conclusion on whether
these amounts are good or bad. The best we can do is identify the common characteristics of
firms with negative FCF (and vice versa for positive FCF firms).
FCF Deficit/Surplus: 7 Minutes
Firms with a FCF Deficit Have the Following Common Characteristics
1. Growth Oriented with Large Business Investments
2. New Ventures that have Not Yet Completed Business

Investments for their Start-up Phase
3. Low Profitability
In order to survive in the long term firms eventually must have positive FCF. However, FCF
deficits in the near term are not necessarily bad. A FCF deficit indicates that a firm is investing
more in new business investments than it can “finance” from its operations. Therefore, it must
sell new financial assets to investors to makeup this deficit. As long as these investments are
productive – that is, they are positive NPV and create wealth, they should be made by the firm.
As financial analysts, we expect that eventually when anticipated FFO benefits of these new
investments begin to accrue and/or incremental investment slows down, FCF will turn positive.
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2.6.2 The Financial Definition of Free Cash Flow
For our purposes, the operating definition of FCF is more important than is the financial
calculation. However, there is information content in the financial calculation, which measures
the sum of all net out flows from a firm to financial asset-holders. If FCF is negative then the net
flow is from financial asset-holders to the firm.
Free Cash Flow =
After Corporate Tax Net Distributions to Debt-holders
plus
Net Distributions to Shareholders
Each of these distributions represents the flow of cash from the firm to financial asset holders.
2.6.3 After Tax Distributions to Creditors

FCFFIN Creditors: 7 Minutes
Net distributions to debtholders is after-tax interest plus principal repayments less the sale of new
debt over the period in question.
After-corporate-tax interest rather than interest itself is used in this calculation for two reasons.
First, interest is tax deductible for the firm, and therefore, the actual cost to the firm of making a
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dollar of interest payment is lesser by the rate of taxation (presuming the firm is in a tax-paying
position). Second, in financial analysis, it is conceptually important to separate the operating
activities of a firm from its financing activities. Because the benefit of interest deductibility to a
firm arises from a financial activity (i.e., borrowing), this benefit should be attributed to this
financing activity in the free cash flow calculation. In other words, from the firm’s perspective,
the “cost” of making interest payments to debtholders is less because of this benefit.
During 2017 TELUS paid interest of $491 (see Exhibit 2-4 above). Their effective tax rate for
2017 is 3.7%. So, the after-tax cost of their dollar interest payment is (other than some rounding),
After Tax Cost of Dollar Interest  566*(1-0.272) = $412
Net new borrowing, which is the difference between the sale of new debt and principal
repayments can be found by taking the difference between end-of-period and beginning-of-
period debt (both short-term and long-term) on the invested capital balance sheet.
∆𝐷𝑒𝑏𝑡 = 𝐷𝐸𝐵𝑇𝐸𝑂𝑃 − 𝐷𝐸𝐵𝑇𝐵𝑂𝑃
= 𝐷𝐸𝐵𝑇17 − 𝐷𝐸𝐵𝑇16
=$15,099-$14,162 = $937
The fact that this number is negative indicates that TELUS has done borrowed incrementally
during 2017. Paying down debt is a payment out from TELUS to a financial asset-holder and
thus has a positive sign in the FCFFIN calculation. In this case, borrowing is a flow in to a firm
from a financial asset-holder and, thus, has a negative sign in the FCF financial calculation.
Principal Repayment (Borrowing) = -$937
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2.6.4 Net Distributions to Shareholders
FCFFIN Shareholders: 20 Minutes
Net distributions to shareholders equal the sum of dividends plus any share repurchases less new
issues of shares.
In Exhibit 2-4, in 2017, we see that TELUS paid shareholder dividends of $1,082 ($US
millions).
Dividends = $1,082
Of course, dividends flow out from TELUS to a financial asset-holder and, thus, dividends have
a positive sign in the FCFFIN calculation.
Finally, TELUS might have either sold new shares to shareholder or repurchased shares from
their existing shareholders. To find out whether TELUS did either of these two things, recall that
book equity is the sum of share capital and retained earnings. EQ stands for book value of
equity,
EQEND=EQBEG + NI – DIV + NEW ISSUE - REPURCHASE OF SHARES
NI stands for Net Income and DIV stands for Dividends. For TELUS in 2017 (see Exhibit 2-3
and Exhibit 2-4, above),
𝐸𝑄17 = 𝐸𝑄16 + 𝑁𝐼 − 𝐷𝐼𝑉 − 𝑁𝐸𝑇𝑟𝑒𝑝𝑢𝑟ℎ𝑎𝑠𝑒
$10,721 = $10,024 +$1,460-$1,082 - NETrepurchase
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Rearrange to find,
NETrepurchase = -$319
Because this number is negative, in 2017, TELUS on net sold new common shares. This net sale
is a flow in to TELUS from a financial asset-holder and, thus, has a negative sign in FCFFIN. On
the other hand, if this amount had been positive, it would be a net repurchase of shares, which
requires cash from Telus and, thus, has a positive sign in FCFFIN.
The financial definition of FCF applied to TELUS for 2017 is
After Tax Interest $412
Debt Repayment (borrowing) -$937
Dividends $1,082
Net Share Repurchase (new issue) -$319
Free Cash Flow (Financial) $238
FCF in the financial definition in the above table equals FCF in the operating calculation as it
should. The financial definition of FCF tells us how a firm has distributed a FCF surplus to its
financial asset holders or how it has financed a FCF deficit from financial asset holders. In 2017,
TELUS distributed to financial-asset holders a FCF surplus, 238 $US million.
FCF Discussion: 3 ½ Minutes
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2.6.5 Trend Analysis for TELUS' FCF
Exhibit 2.5 below reports TELUS’s FCF in the operating and financial calculations 2011-2017.
This table is one of the spreadsheets in the TELUS workbook that begins section 2.3 above.
Notice that there is no obvious trend for TELUS’s FCF: sometimes it is high, sometimes it is
low, and sometimes it is negative but, generally, Telus has positive FCF because as we will learn
shortly, it is not a high growth company. This simple trend analysis is consistent with our
observations above that neither positive nor negative FCF is necessarily bad or good.
Exhibit 2-5
Telus Free Cash Flow
2011 2012 2013 2014 2015 2016 2017
FFO (bottom up) 3,308 3,448 3,377 3,591 3,659 3,685 4,054
∆TC 1,492 -39 -207 -388 -31 -61 248
CAPX 1,488 2,225 2,813 3,636 4,956 3,220 3,568
FCF (OP) 328 1,262 771 343 -1,266 526 238
After Tax Interest 294 260 272 324 365 403 412
Debt Repay -1,749 -119 -199 -1,922 -2,576 -903 -937
Dividends (total) 642 774 852 913 992 1,070 1,082
Repur 1,141 347 -154 1,028 -47 -44 -319
FCF (fin) 328 1,262 771 343 -1,266 526 238
(2.7) The Cost of Capital

In this E-Finance book, we use discounted cash flow analysis (DCF) as our theory of value and
financial statements and financial market data as inputs to answer the questions of financial
analysis we identified in chapter 1. We forecast prospective corporate business returns for all
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financial asset-holders and shareholders in particular, which we then benchmark with objective
opportunity cost rates of return from financial markets. We need firm-specific information from
financial statements to forecast business returns and financial market measures to calculate
investor opportunity cost rates of return. For the purpose of this analysis, with some simplifying
assumptions (that might not be appropriate for all firms), in this section, we illustrate how to
calculate a firm’s cost of capital to help answer the question whether or not a firm makes “good”
business investments for financial asset-holders and shareholders in particular. The cost of
capital is the opportunity cost rate of return for a firm’s business investments.
To begin our journey, in the next sub-section, we investigate the economic determinants of FCF.
This analysis tells us that we need ROIC and corporate growth forecasts to forecast FCF. Next,
we forecast ROIC from ROE. We put these analysis-components together with the consensus
analysts’ growth forecast (from the investment industry), to forecast future FCF.
2.7.1 ECONOMIC DETERMINANTS OF FCF
There are two primary economic determinants of FCF: corporate profitability and growth.
In addition to the bottom-up calculation (above), there is also a “top down” calculation for FFO.
FFO (top down) = (1-t)*(EBITDA-deprec) + deprec
where “t” is the corporate tax rate and “deprec” is depreciation for both tax purposes and for
financial reporting (we presume). With this presumption, one can prove (but we will not), that
FFO in the top-down calculation equals FFO in the bottom-up calculation. These are two ways of
calculating the same thing.
Corporations make two types of capital expenditures: to maintain the quality of existing
depreciable assets to prevent economic deterioration (like changing the roofing of an apartment
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building to prevent leakages) and for growth (like adding a building to existing buildings of a
real estate company). Let’s use the acronym MCAPX to describe a firm’s maintenance capital
expenditure (also called “sustaining” capital expenditures) and GCAPX to describe growth
capital expenditures. The sum of maintenance and growth capital expenditures equals total
capital expenditures,
CAPX = MCAPX + GCAPX
With this notation and the top down calculation for FFO, write FCFop as:
FCFOP = FFO - ∆𝑇𝐶 – CAPX
= (1-t)*(EBITDA-deprec) + deprec - ∆𝑇𝐶 – MCAPX - GCAPX
Now, suppose that accounting depreciation is an economic forecast of MCAPX. Then, deprec =
MCAPX. So, simplify the above,
FCFOP = (1-t)*(EBITDA-deprec) - ∆𝑇𝐶 - GCAPX
Suppose now that a business grows at g% per annum. This growth requires incrementing both
trade capital, TC, and depreciable asset investment, NFA, by g% per annum. Thus,
∆𝑇𝐶 = 𝑔 ∗ 𝑇𝐶
where TC is trade capital at year-beginning. And,
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𝐺𝐶𝐴𝑃𝑋 = 𝑔 ∗ 𝑁𝐹𝐴
where NFA is net fixed assets at the beginning of the year.
Add these amounts,
∆𝑇𝐶 + GCAPX = 𝑔 ∗ 𝑇𝐶 + 𝑔 ∗ 𝑁𝐹𝐴 = 𝑔 ∗ (𝑇𝐶 + 𝑁𝐹𝐴) = 𝑔 ∗ 𝐼𝐶,
(since, IC = TC + NFA). With this expression for growth investment (that is, 𝑔 ∗ 𝐼𝐶),
FCFOP = (1-t)*(EBITDA-deprec) - 𝑔 ∗ 𝐼𝐶.
Recall (equation 2.2) that the rate of return on invested capital after tax and after depreciation is,
(1 − 𝑡) ∗ (𝐸𝐵𝐼𝑇𝐷𝐴 − 𝑑𝑒𝑝𝑟𝑒𝑐)
𝑅𝑂𝐼𝐶 =
𝐼𝐶
So, we can write FCFOP as,
FCFOP = 𝑅𝑂𝐼𝐶 ∗ 𝐼𝐶 - 𝑔 ∗ 𝐼𝐶 = (𝑅𝑂𝐼𝐶 − 𝑔) ∗ 𝐼𝐶 (2.3)
This FCFOP expression illustrates two things. First, when profitability of a business, as measured
by the rate of return on invested capital after tax and after deprecation, increases (other things
equal), operating free cash flow also increases. Second, high growth companies (that is,
companies with high “g”), have low operating free cash flow (and, possibly even negative). Of
course, these businesses make investments to increase future profitability (EBITDA) and free
cash flow for the benefit of all financial asset-holders and shareholders in particular.
Just to put some numbers on the above operating FCF formula, suppose that a firm has invested
capital of 10 million dollars, a rate of return on invested capital after tax and after depreciation of
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20% per annum, and growth investments of 5% per year. Then, we can forecast operating free
cash flow as,
(0.20 − 0.05) ∗ 10 = 1.5 million dollars.
Of course, as this business grows with growth investments, we expect FCF to grow in the future
as well (at 5% per annum).
Below is a sample problem with solution that illustrates the primary economic determinants of
FCF in the operating calculation are business return and corporate growth.
Value of a growing business we measured by PV (after business investment) as,
𝐹𝐶𝐹
𝑃𝑉 = 𝑟−𝑔,
where FCF is operating free cash flow forecast in one year, r is the opportunity cost rate of
return, and g is the per annum rate of corporate growth. The opportunity cost rate of return for
business investment is called the cost of capital.
PROBLEM: Today, ABC Company is planning a business investment. ABC is a start-up firm
and, therefore, it has no investments or assets (for example, ABC has no cash balance). Also,
ABC has no other business investments planned or contemplated other than the one described in
this problem. For an investment (expenditure) of $I today, the expected cash flow (free cash
flow) to ABC at the end of the current year is $C which then grows at the rate g% per annum
indefinitely. That is, each cash flow after the first is 1+g greater than the previous. Currently,
ABC has no debt in its financial structure and its book equity is zero. Book equity is the sum of
share-capital and retained earnings. In order to undertake its investment, ABC needs to do some
financing. They plan to sell new shares to new shareholders in the amount of $I to finance their
business investment. The financial market opportunity cost (expressed as a rate of return) facing
the shareholders of ABC for this business investment is 12% per annum. ABC’s market to book
ratio for equity immediately after the share issue and the capital expenditure for assets to start the
business is 2.5. The IRR on the business investment (rate of return on invested capital after tax
and after depreciation) is 20% per annum.
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Required: Find g, the percentage growth in per annum cash flows.
Solution
FCF Operating
2.7.2 FORWARD ROIC
Since (equation 2.3 above),

FCFOP = (𝑅𝑂𝐼𝐶 − 𝑔) ∗ 𝐼𝐶,
we can forecast FCF for the upcoming period (year, generally) with a ROIC forecast and a
growth forecast. Also, since (equation 2.1 above),
Debt BVE
ROIC  (1  t )* rD *  ROE *
IC IC
we can forecast ROIC by forecasting (or measuring) the components of the right-hand-side of
this equation. Let us begin by forecasting ROE.
Let P/E be the price to forward earnings ratio (forecast earnings). Forward earnings (per share)
might be your earnings forecast, but for our analysis we use what is called the consensus
earnings forecast (for approximately one year hence) for a public company by financial analysts
from around the world who monitor and investigate the company of our study (for their clients).
The consensus earnings forecast is the average forecast of financial analysts. A number of
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financial information firms, like, for example, Standard and Poors (S&P) continuously collect,
average, and report consensus forecasts for a multitude of public companies. “Price” is share-
price today. Next, let P/B be the market to book ratio for the equity of a company (price to book).
“P” is share price today and “B” is book value of equity per share.
Then, we can forecast ROE (forward ROE) as
𝑃/𝐵 𝐸
= = 𝑅𝑂𝐸𝐹𝑂𝑅
𝑃/𝐸 𝐵
Click on the below icon to see how I collect share price, # shares outstanding, the price to
forward earnings ratio, and financial analysts’ consensus growth forecast from
www.yahoofinance.com on November 26, 2018 to forecast ROE.
Forecasting ROE
So, at November 26, 2018 for TELUS, #shares outstanding = 598 (million), share price = 35.91,
the price to forward earnings ratio = 15.55, and the consensus analyst growth forecast = 4.7% per
annum. In addition, from Exhibit 2-3, for year-end 2017 for TELUS, IC=25,820 (almost 26
billion dollars), BVE=10,721 (over 10 billion dollars), and BVD (book value of debt) = 15,099
(over 15 billion). The market value of all of TELUS’s common shares is the market value of
equity (market capitalization). With these numbers,
𝑃 𝑀𝑉𝐸 598∗35.91 21,474

= = = 10,721 = 2.003
𝐵 𝐵𝑉𝐸 10,721
Thus, forecast ROE as,
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𝑃/𝐵 2.003
𝑅𝑂𝐸𝐹𝑂𝑅 = 𝑃/𝐸 = 15.51 = 12.9% / annum.
So, our forecast ROE is less than realized 2017 ROE, 12.9% < 14.4%.
Now that we have an ROE forecast, we can forecast ROIC with (equation 2.1 above)
Debt BVE
ROIC  (1  t )* rD *  ROE *
IC IC
by completing the measures on the right-hand-side. For this purpose, let us use amounts from the
Invested Capital Balance sheet for year-end 2017 from Exhibit 2-3 above (if you don’t like these
numbers as forecasts, you can use your own),
15,099 10,721
𝑅𝑂𝐼𝐶 = (1 − 0.272) ∗ 0.039 ∗
25,820
+ 0.129 ∗
25,820
= 0.07.
So, our ROIC forecast for TELUS is 7.0% per annum for both existing business investments and
future growth investments (we presume). Notice from Exhibit 2-3 our ROIC forecast is less than
realized ROIC for 2011-2017.
2.7.3 FORWARD ROIC for McDonalds

Forecasting ROIC with the right-hand-side of equation (2.1), like we have just done for TELUS,
is problematic if book-equity (BVE) is negative or close to zero. In this case, ROE is either
undefined or economically unrealistic. Further, there is a tendency for this phenomenon to arise
more frequently recently even for some very profitable and large US public companies, like, for
example, McDonalds. Rather than with dividends, because of favorable personal tax treatment of
capital-gains in the US tax-code, there is a tendency for US corporations to distribute the benefit
of their profitability to shareholders with share-repurchase programs, which, other thing equal,
decreases book-equity. Dividends also reduce book-equity but, as a rule, companies pay
dividends out of permanent rather than transitory earnings. So, US firms use share-repurchase
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programs to make large (often temporary and transitory) distributions to shareholders as share-
repurchases. The phenomenon is not as pronounced in Canada because of a personal-tax
preference for dividends over capital gains in the Canadian tax-code. So, we have the peculiar
phenomenon for our financial analysis that some very profitable US companies have negative
book-equity. In the below embedded spread-sheet, you can see in the “IC” tab, that McDonalds
book-equity has fallen from $15.967B at year-end 2010 to -$2.149B at year-end 2017 even
though invested-capital has increased from $29.059B to $30.913B.9
McDonalds
We can deal with the negative BVE phenomenon in our financial analysis by forecasting ROIC
directly with equation (2.2) rather than indirectly with equation (2.1). Recall that there are two
ways to calculate ROIC and, thus, there are also two ways to forecast ROIC. In particular, we
can forecast ROIC with an adjusted EPS forecast. Most importantly, any earnings calculation
subtracts $INT (after tax), and, thus, to eliminate $INT for an operating measure of business-
return we add back forecast after-tax $INT,
NI + (1 − t) ∗ $INT = (1 − t) ∗ (EBITDA − deprec − $INT) + (1 − t) ∗ $INT
= (1 − t) ∗ (EBITDA − deprec)
which is the numerator of ROIC (after tax and after depreciation).
Let EPS = forecast earnings per share approximately but at least one year hence, N = # shares
outstanding, t = forecast corporate tax rate, $INT = forecast dollar interest in the upcoming year.
Then, we can forecast ROIC as,
9
Despite high profitability, IC of McDonalds has not increased substantially over this period because of large share-
repurchases (see the FCF tab in the McDonalds embedded spreadsheet).
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𝑁 ∗ 𝐸𝑃𝑆 + (1 − 𝑡) ∗ $𝐼𝑁𝑇
𝑅𝑂𝐼𝐶 =
𝐼𝐶
This forecast presumes that financial statement depreciation forecasts capital expenditures that
maintain the quality of existing depreciable assets (MCAPX) to prevent economic depreciation.
For McDonalds, MCAPX is largely (most likely) modernizing renovations for restaurant
locations.
For McDonalds (Nov 29, 2018) from either www.yahoofinance.com or the above embedded
spreadsheet: EPS = $8.23 (year-end 2019, see the “Analysis” tab for MCD at
www.yahoofinance.com), N = 770.91 (million shares), $INT = rD * DEBT2017 = 0.03 * 33,062 =
991.86 ($US million), t = 0.394, IC2017 = $30,913 ($US millions).
Thus, our 2019 ROIC forecast for McDonalds is,
770.71∗8.23+(1−0.394)∗991.86 6,944.01
𝑅𝑂𝐼𝐶2019 = = = 22.46%
30,913 30,913
A simple trend analysis from the above embedded McDonalds spreadsheet illustrates that this
forecast is not greatly different from realized ROIC for recent years. McDonalds is indeed a very
profitable company.10
2.7.4 Forecasting $FCF, generally
For TELUS, we now we have forward ROIC (ROIC=7.0% per annum), a growth forecast
(consensus analysts’ growth forecast, g=4.7% per annum from above the “Analysis” tab for
10
For McDonalds, if one uses the indirect method (equation 2.1) to forecast ROIC even though ROE and P/BVE are
economically unrealistic, the forecast of ROIC, nonetheless, is very similar to that which we have just calculated
(22.46%) with the direct method (equation 2.2).
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ticker symbol TL at www.yahoofinance.com), and IC17 = 25,820 (Exhibit 2-3). So, we can
forecast TELUS’s FCF18 with equation (2.3) above,
𝐹𝐶𝐹𝐶𝑃𝑅,2018 = (𝑅𝑂𝐼𝐶 − 𝑔) ∗ 𝐼𝐶 = (0.07 − 0.047) ∗ 25,820 = 596 ($US millions)
So, we forecast positive FCF for TELUS in the upcoming year.
2.7.5 The Constant Growth Cost of Capital
Suppose a company makes year-end growth investments equal g% of beginning of year invested
capital, indefinitely. This presumption means that our analysis is appropriate only for firms for
which we can presume constant indefinite growth. Constant growth companies have a number of
common features: they are mature rather than new ventures, they are profitable, and, they are
relatively large (because they have undertaken successful past business endeavors). In addition,
to access public financial analysts’ forecasts, we also restrict our analysis to public rather than
private firms. Last, generally, although not always, the firms we investigate often pay
shareholder dividends currently over a regular interval (like, for example, quarterly). While our
analysis is strictly only appropriate for this class of corporation, this class represents most of the
largest and most important economic businesses in our world economy.
We can observe (or calculate) a firm’s asset market-to-book ratio from financial market
information sources. In addition, discounting forecast future FCF at the cost of capital and
dividing by invested capital gives us a theoretic asset market-to-book ratio. Setting the observed
ratio equal its theoretic DCF equivalent, we can work backwards to calculate a firm’s cost of
capital: the business-investment opportunity cost rate of return implied by the observed asset
market/book ratio and constant growth DCF. Thus, we call this amount the constant growth
implied cost of capital. We illustrate these methods for TELUS.
First, a common way to calculate a firm’s MVA ─ Market Value of Assets (Enterprise Value) ─
is Market Value of Equity (MVE) plus book-value of debt (BVD). BVD is an approximation to
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market value of debt (MVD), which is generally appropriate because most corporations use
short-term rather than long-term debt. In refinancing debt in short-term sequences, market values
never diverge far from borrowed values – book value. As we learn in chapter 7, alternatively,
long-term corporate bonds that have fixed coupon rates (interest rates) that differ significantly
from yields (the opportunity cost rate of return for a bond) can have market values that differ
greatly from book-values (so called, par-value of a corporate bond).
For TELUS for Nov 26, 2018,
MVA (Enterprise Value) = MVE + BVD = $21,474 + $15,099 = $36,573
(over 36 billion $US)
So, at Nov 26, 2018, TELUS’s observed asset market/book ratio is:
𝑀𝑉𝐴 36,573
= = 1.416
𝐼𝐶 25,820
Second, let’s calculate the asset market/book ratio from a theoretic DCF perspective. In DCF,
MVA is discounted growing predicted future FCF. Recall we forecast FCF in one year as
FCF=[ROIC-g]*IC.
Recall that for a growing business, value (MVA), measured by PV (after business investment), is
𝐹𝐶𝐹
MVA = PV = ,
𝑟−𝑔
where FCF is operating free cash flow forecast in one year, r is the opportunity cost rate of return
for business investment – the cost of capital – and g is corporate growth.
Substitute the FCF expression into the numerator of the above, to find,
[𝑅𝑂𝐼𝐶−𝑔]∗𝐼𝐶
𝑀𝑉𝐴 = .
𝑟−𝑔
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Divide both sides by IC to find the DCF representation of the asset market to book ratio,
𝑀𝑉𝐴 [𝑅𝑂𝐼𝐶−𝑔]
= (2.4)
𝐼𝐶 𝑟−𝑔
Now we have an observed asset market-to-book value from financial markets and a theoretic
asset market-to-book from DCF. Set these two market/book measures equal to one another. In
this equality, we presume that financial markets use the same theory of value as you and I, DCF,
𝑀𝑉𝐴 [𝑅𝑂𝐼𝐶 − 𝑔]
= 1.416 =
𝐼𝐶 𝑟−𝑔
Now, complete the right-hand-side equation (2.4) with our ROIC forecast from above and the
consensus analyst growth forecast we collected from financial markets information sources,
𝑀𝑉𝐴 [0.07−0.047]
= 1.416 = (2.5)
𝐼𝐶 𝑟−0.047
Solve this equation to find the cost of capital implied by this observed asset market/book ratio
and constant growth DCF. So, the constant growth implied cost of capital ─ the opportunity cost
rate of return for TELUS’s business investments ─ is, r = 6.3%.
Notice that in calculating TELUS’s cost of capital, we have not used financial market measures
related to shareholder dividend payment, like, for example, dividend yield. So, while TELUS
pays shareholder-dividends, not all companies do. We can, nonetheless, apply this constant
growth implied cost of capital methodology to non-dividend paying firms.
Exhibit 2-6 below, summarizes our results, not only for TELUS, but, also, for a number of
additional US and Canadian companies using a similar methodology. Notice that the constant
growth cost of capital varies from a low of 6.1% for TransCanada Corp (pipelines and energy) to
a high of 22.7% for Costco (household and food retail). Analysts’ expectation of growth is
highest (24%) for Costco and Premium Brands (food processing and distribution) and lowest (-
1.2%) for Macy’s (consumer retail).
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Exhibit 2-6
Constant Growth Cost of Capital
(November 2018)
Asset ROIC Analysts' Constant Growth

Company
Market/Book Forward Growth Forecast Cost of Capital
TransCanada Corp 1.076 0.061 0.058 0.061

Telus 1.416 0.070 0.047 0.063
Premium Brands 2.628 0.136 0.240 0.200
Canadian Pacific Railway 2.068 0.120 0.124 0.122
Costco 5.047 0.173 0.240 0.227
Macy's 1.246 0.100 -0.012 0.078
Verizon 1.765 0.121 0.059 0.094
Paypal 5.407 0.183 0.2051 0.201
Walmart 2.530 0.117 0.042 0.071
McDonalds 5.77 0.225 0.093 0.117
We have been somewhat indiscriminant in our application of the constant growth presumption in
Exhibit 2-6. The cost of capital exceeds forward ROIC for Premium Brands, CPR, Costco, and
Paypal, which is rather troubling for high growth companies. With companies for which
analysts’ long-term growth forecast exceeds forward ROIC (negative FCF firms), we might,
alternatively, use some type of multi-stage growth modeling that incorporates expectations for
when FCF will become positive. Corporate profitability might not justify high growth rates,
indefinitely. In lieu of this modeling, we should use cost-of-capital calculations in Exhibit 2-6
with caution. On the other hand, in Chapter 8 we find that forward ROE exceeds shareholders’
opportunity cost rate of return for all of these firms, which suggests that growth is an appropriate
corporate objective and that the constant growth presumption might not be amiss.
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2.7.6 Financial Analysis and the Cost of Capital
So, now that we have calculated TELUS’s cost of capital as 6.3% per annum, how is that number
useful for financial analysis?
Remember from Chapter 1 that we benchmark corporate performance with the opportunity cost
rate of return for business investment, which is the cost of capital. With this number, we can
investigate the principal question of financial analysis: does TELUS create wealth for financial
asset-holders and shareholders, specifically, with its business investments?
Wealth creation by firms is inextricably bound to the workings of financial markets. Business
asset-values depend on investors’ opportunity costs rates of return, which, in turn, represent
return expected from alternative financial investments. Shareholders who believe that a firm will
not earn the opportunity cost of capital sell their shares. If many shareholders share a negative
opinion, share prices fall until the market price reflects a fair rate of return. Falling share prices
reduce capital available to managers. In this way, markets work to reallocate capital, increasing
the resources available to managers who succeed to earn at least the opportunity cost of capital
and decreasing the resources available to unsuccessful managers.
So, what about TELUS, specifically?
Recognize that our analysis and presumptions are sufficiently crude that any amount we
calculate should not interpreted as being unduly exact. So, with a forward ROIC for business
investment of 7% and a cost of capital of 6.3%, it is reasonable to conclude that TELUS’s
corporate performance is just meeting the expectations of financial investors.
Also recognize that a forward ROIC of 7% per annum represents an average of all of TELUS’s
business investments, some that are likely more profitable with IRRs greater than this amount
and some that are likely less profitable with IRRs less than this amount. So, by
selling/disposing/liquidating some operations TELUS might be able to increase shareholders’
wealth (by eliminating negative NPV investments). Remember that we presume that the
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objective of managers in operating a business is to maximize shareholders’ wealth. So, if TELUS
can increase shareholders’ wealth by curtailing and/or selling some value destroying operations,
then it should do so. Since, TELUS is a public company, by eliminating negative NPV
investments share price should increase to the immediate benefit of shareholders. However, be
careful, TELUS operates in a regulated telecommunications. Some of their operations that may
not enhance shareholder wealth but they serve a broader national purpose mandated by
government.
Recall in our analysis that we benchmark business returns against financial market returns of
about the same risk as the business investment under study. For TELUS, specifically, how can
we be sure that its 6.3% cost of capital (above) represents the rate of return on a portfolio of
financial assets of about the same risk as TELUS’s business investments? The answer to this
question is that financial markets have determined (according to our calculations) that business
investments of TELUS have a value of $36. ,573 $US billion dollars and an asset market/book
ratio of 1.416. In arriving at these values, financial markets employ a cost of capital
(conceptually) like you and I with the same DCF theory of value as you and I. If the risk of
TELUS’s business investments was greater, then these values would be lower (and the cost of
capital that we calculate would be greater). Similarly, if the risk of TELUS’s business
investments was lesser, then these values would be higher. Presumably, financial markets use a
cost of capital that represents the expected rate of return on a portfolio of financial assets of
about the same risk as TELUS’s business investments. In working backwards from financial
market forecasts and observables in equation (2.5), we uncover the cost of capital that financial
markets use with this equivalent risk property. Whenever use financial market determined values
(prices) to calculate an IRR (which is what we have done with the TELUS cost of capital
calculation above), then the IRR is risk-adjusted. For example, in chapter 7 we study bonds
(publicly traded debt): a bond yield has this risk-adjusted feature.
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(2.8) Summary
Financial accounting is the process of producing and disseminating information about the
economic activities of a firm. Annual and quarterly reports, and more specifically financial
statements, transmit this information to interested individuals and groups. Users of financial
statement information include shareholders, creditors, employees, suppliers, government, and
social interest groups. Financial statements are general-purpose summaries of economic activity
because user groups have diverse interests. A goal of this E-Finance book is, therefore, to
describe how investors can use financial statement information to analyze a firm for potential
investment.
We use discounted cash flow analysis (DCF) as our theory of value with financial statements and
financial market data as inputs to answer the primary question of financial analysis: does the firm
under investigation make good business investments for its financial asset holders and its
shareholders in particular. We forecast prospective corporate business returns and, then,
benchmark these with objective financial market opportunity cost rates of return. We need firm-
specific information from financial statements to forecast business returns and financial market
measures to calculate investor opportunity cost rates of return. We calculate a firm’s cost of
capital implied by an observed asset market/book ratio (from financial markets) and constant
growth DCF presumption.
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(2.9) Suggested Readings
1. The Canadian Securities Course. Toronto: The Canadian Securities Institute, 1995.
2. Robert C. Higgins. Analysis for Financial Management, fifth ed. Chicago: Irwin, 1998.
3. Erich A. Helfert. Techniques of Financial Analysis, eighth ed. Chicago: Irwin, 1994.
4. Diana R. Harrington and Brent D. Wilson. Financial Analysis, third ed. Chicago: Irwin,
1989.
5. Kenneth Hackel and Joshua Livant Cash Flow and Security Analysis, Chicago, Business-
One Irwin, 1992.
6. Soenen, L.A, “Cash Conversion Cycle and Corporate Profitability,” Journal of Cash
Management (July/August, 1993), 53-57.
7. G.I. White, A.C. Sondhi, D. Fried. The Analysis and Use of Financial Statements. New York:
John Wiley & Sons, 1994.
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(2.10) Problems
1. Financial Statements and Free Cash Flow.
Based on the following information for ABC Ltd., prepare an income statement for 1999 and
balance sheets for 1998 and 1999. Assume a flat 40% tax rate throughout. Next, for 1999,
calculate Funds From Operations, Change in Invested Capital, and Free Cash Flow. Find net
distributions to debtholders and net distributions to shareholders. Verify that free cash flow is
equal to the sum of net after corporate tax distributions to debtholders and net distributions to
shareholders. There is no deferred tax in this problem, so you can reasonably assume that
financial statement depreciation and depreciation for tax are equal.
Selected Information for ABC, Ltd
(All figures in thousands)
1998 1999
Sales $3,790 $3,990
Production Costs 2,043 2,137
Depreciation 975 1,018
Interest 225 267
Dividends 200 205
Current Assets 2,140 2,346
Net Fixed Assets 6,770 7,087
Accounts Payable 994 1,126
Long-term Debt 2,869 2,956
Solution
2. Invested Capital, ROIC, Trade-Capital, Free Cash Flow.
ABC Co. Ltd. has the following year-end accounting balance sheet.
Current Assets $500,000 Accounts Payable $200,000
Net Fixed Assets $1,500,000 Short-Term Debt 400,000
Equity 1,400,000
Equity on the balance sheet represents the sum of all the accounting “equity” accounts. Expected
sales for the upcoming year are $4,500,000. Costs of goods sold are 65% of sales and other
operating expenses are $850,000. The interest rate on ABC’s short-term debt is 10% per annum.
ABC’s tax-rate is 23%. ABC expects to maintain the level of its short-term debt into the
indefinite future.
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a) Calculate ABC’s invested capital turnover, EBITDA margin, and rate of return on
invested capital (before tax, no depreciation in this problem).
b) ABC anticipates no capital expenditure in the upcoming year. ABC expects to pay
dividends equal to net income. Find free cash flow, net after corporate tax distributions
to debtholders and net distributions to shareholders. Does ABC have a free cash flow
surplus or deficit? If ABC has a free cash flow deficit, how is it financed? If ABC has a
free cash flow surplus, how is it distributed?
c) ABC intends to expand its operations. Sales are expected to increase by $1,000,000 per
annum. In addition, “other” operating expenses will increase by $200,000 per annum.
Costs of goods sold, as a fraction of sales is not expected to change. This expansion
requires a one-time incremental investment of $400,000 in trade capital and a capital
expenditure in the amount of $300,000. ABC intends to finance these expenditures with
long-term debt. Does ABC’s before tax rate of return on invested capital (for the entire
firm) increase or decrease as the result of the expansion?
d) What is the after tax IRR on the business expansion?
Solution
3. Rate of Return on Assets and Rate of Return on Invested Capital.

Compare and contrast the rate of return on “invested capital” and the rate of return on
“assets” as measures of corporate performance for evaluating the financial health of a firm.
Solution
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4. The EBITDA Margin.
The range for EBITDA margin for industries in the US and Canadian economy is from
approximately zero to about 60%. What characteristics of industries lead to high or low
EBITDA margin? Explain and discuss.
Solution
5. ROA versus ROIC
This question is adapted from Analysis for Financial Management by Robert C. Higgins, fifth
ed. Chicago: Irwin, 1998.
The rate of return on assets is a commonly used ratio that is calculated as net income divided
by the accounting definition of assets. The purpose of this question is to illustrate that the
rate of return on invested capital is a better measure of the rate of return on business
investment. In this question, invested capital and “assets” are the same. Ignore depreciation
in this problem.
You have the following information for ABC Co. Ltd.
Earnings before interest and tax $100

Interest Expense 5
Earnings before tax 95
Tax at (30%) 28.5
Earnings after tax 66.5
Assets = Invested Capital = $500, Equity = $450
a) Calculate ABC’s ROE, ROA, and ROIC times one minus the tax-rate.
b) Suppose that ABC recapitalizes by selling $200 million in debt at 10% per annum. ABC
uses the proceeds of this financial-asset sale to repurchase $200 million of its common
shares. Presume that this recapitalization has no effect on ABC’s operating performance
(in other words, ROIC is not expected to change after the recapitalization). Calculate
ABC’s ROE, ROA, and ROIC times one minus the tax rate. Explain why ROA is an
inadequate measure of the rate of return to business investment.
c) Give two reasons for the increase in ROE after the recapitalization. Discuss some of the
advantages and disadvantages of debt use by firms.
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Solution
6. The EBITDA Margin.

Explain the significance of EBITDA margin in financial analysis.
Solution
7. Free cash flow and net distributions to financial asset-holders.

ABC is a non-growing firm: it retains no earnings and pays all residual cash flows after
interest and tax to shareholders as dividends. ABC is financed with common shares and
short-term debt. ABC’s trade capital equals inventory plus accounts receivable less accounts
payable. Ignore depreciation for reporting and tax in this problem.
ABC sells widgets. Projected sales are 1,000,000 units per annum into the future. Product
price is $2.80 per unit. Costs of goods sold equal 60% of Sales. General and administrative
expenses are $100,000 per annum. ABC’s accounts receivable turnover is 6.5. Inventory
turnover is 5.5. Accounts payable turnover is 4.0.
ABC’s past expenditure into capital assets is $2,225,000. ABC has financed its operations
(in part) with $1,000,000 in short-term debt that pays interest at a rate of 12% per annum
(paid annually). ABC’s only other financial asset is common equity. ABC anticipates to
make no additional expenditures in the foreseeable future on capital assets. ABC pays
annual dividends equal to Net Income, and therefore, ABC is a non-growing firm. The
corporate tax rate is 35%. There are 1,000,000 shares of ABC stock, which trade on the
Newton stock exchange.
a) Find the rate of return on equity for ABC.
b) Decompose ABC’s rate of return on equity into the product of net profit margin, asset-
turnover, and the asset to equity ratio. In these calculations, use invested-capital as your
definition of assets.
c) ABC is contemplating a change in its product pricing policy, which may require changes
in its trade-capital investment. If ABC reduces its product price to $2.70 per unit it
anticipates an increase in per unit sales to 1,200,000 units per annum. As the result of
increase in per annum dollar sales, what will be the new level of trade capital for ABC?
Accounts receivable turnover, inventory turnover, and accounts payable turnover are not
expected to change.
The remaining parts of this problem relate to the policy change described in (c).
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d) ABC repurchases no shares over the year. In addition, they sell no new shares. ABC will
use short-term debt for any required financing (at the end of the year). How much will
ABC need to borrow at the end of the year?
e) Find Funds from operations for ABC. Find incremental business investment. Find Free
Cash Flow.
f) Find Net Distributions to Shareholders. Find Net Distributions to Debtholders.
Solution
8. ROE
Consider the following invested capital balance sheet for ABC Company for year-end 1994.
Trade Capital 3,200,000 s.t. debt 1,900,000

Common Equity 600,000
Net Fixed Assets 800,000 Retained 1,500,000
Earnings
ABC has a contribution margin per dollar sales of 20%. (Contribution margin is defined as
unit product/service price minus unit variable cost dividend by unit price). Fixed costs per
annum (before depreciation) are $200,000. Dollar sales for the upcoming year are expected
to be $3,000,000. The interest rate on short-term debt is 10% per annum. ABC expects no
incremental business investment for the year. ABC’s tax-rate is 35%. Depreciation for tax
and reporting is 15% per annum.
a) Find expected net income for the upcoming year.
b) Find after-tax expected funds from operations.
c) Calculate the rate of return on equity.
Solution
9. The Current Ratio.

A firm has current assets of $500,000. What is the change in the current ratio (now equal to
2.0) if the following actions are taken independently? In other words, you should have five
separate responses for the five parts of this problem below. Other than the common
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information given on current assets and the current ratio, information from no one part of the
question should be used in any other part.
a) pays $77,500 of accounts payable with cash.
b) collects $43,000 in accounts receivable.
c) purchases merchandise worth $51,300 on account.
d) Sells production machinery for $90,000.
e) Sells merchandise on account that cost $53,500. Gross profit margin is 33%.
Solution
10. Financial Analysis.

There are three principal questions a financial analyst or investor must investigate for any
investment. Identify these questions. Suppose you are a financial analyst who is charged
with evaluating the performance of a corporation over the recent past. Discuss the measures
and ratios that you might calculate to answer or investigate these questions for the firm under
consideration.
Solution
2-63
11. Ratio Analysis in EXCEL.
Below is an embedded “workbook” composed of three worksheets. The first worksheet is an
income statement and the second is a balance sheet. In the third worksheet, calculate the
indicated financial ratios for each of the years 1990-1993. In every cell of this solution
template, you should replace the “X” cell identifier with a spreadsheet formula that uses
inputs from the first two worksheets to calculate the indicated ratio. The tax rate for the firm
in this problem is 36%. A suggested solution is contained in the second embedded workbook
entitled “Solution”.
Template Solution
12. Calculate Free Cash Flow.

The following information is available on the financial accounts of ABC Corporation.
1999
Sales 1,600
Cost of Goods Sold 800
General and Administrative Expenses 250
Interest 50
Depreciation 40
tax at 40% 184
1998 1999
Accounts Receivable 150 ?
Inventory 200 ?
Net Fixed Assets ? ?
Short Term Debt 500 ?
Accounts Payable 100 ?
Equity ? ?
NOTE: “Equity” represents the sum of all of the accounting equity accounts.
The following additional financial information is available for ABC.
The rate of return on invested capital (b.o.p.) after tax and after depreciation for 1999 is
15.3%. This return is calculated as EBITDA less depreciation times one minus the tax rate
divided by beginning of period invested capital. Dividends for 1999 are $85. ABC paid off
its short-term debt in 1999 and sold additional common shares. In 1999, inventory turnover
was 4.0, the accounts payable deferral period was 40 days, and the cash conversion cycle was
60 days. The component ratios of the cash conversion cycle are calculated using 365 days in
a year. In addition, these ratios use only the 1999 financial statements (i.e., not beginning of
period balance sheet amounts). Capital expenditure in 1999 was $135.
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Required : Based on the information at hand, find free cash flow using both the operational
and the financial definitions for 1999.
Solution
13. Calculate Free Cash Flow.

1999
Sales ?
Cost of Goods Sold ?
Interest 50
Depreciation 40
tax at 40% 274
1998 1999
Accounts Receivable 150 200
Inventory ? ?
Net Fixed Assets ? 3056
Accounts Payable ? 100
Equity ? ?
The rate of return on invested capital (b.o.p.) after tax and after depreciation for 1999 is
15.0%. This return is calculated as EBITDA less depreciation times one minus the tax rate
divided by beginning of period invested capital. Dividends for 1999 are $95. ABC
incremented the level of its short-term debt by $300 in 1999. ABC repurchased $200 of its
outstanding shares in 1999. Incremental investment in trade capital in 1999 was $145. In
1999, inventory turnover was 4.0, the accounts receivable collection period was 40 days.
The accounts receivable collection period is calculated using 365 days in a year. In addition,
inventory turnover and the accounts receivable collection period use only the 1999 financial
statements (i.e., not beginning of period balance sheet amounts).
2-65
Required: Based on the information at hand, find free cash flow using both the operational
and the financial definitions for 1999.
Solution
14. Free Cash Flow and the Invested Capital Balance Sheet.
1996
Sales 2,000
Cost of Goods Sold 1,400
Interest 60
depreciation (which equals depreciation for tax) 35
corporate tax rate ?
1995 1996
Accounts Receivable 268 ?
Inventory 100 ?
Net Fixed Assets 3000
Accounts Payable 200 ?
Equity ? 2,517
ABC has a trade capital to sales ratio of 10% (i.e., trade capital for the end of the fiscal year
divided by sales for that same year). ABC has financed its operations with short-term debt and
with common equity. Dividends for 1996 are $95. ABC borrowed additional short-term debt in
1996. They also repurchased $200 of shares in 1996. Free cash flow in 1996 was $25.
2-66
Required: Based on the information at hand, and the definition(s) of free cash flow, determine
the invested capital balance sheet for ABC for both 1995 and 1996. For each year find trade
capital, net fixed assets, short-term debt and “equity.” What was ABC’s corporate tax rate in
1996? What was ABC’s expenditure for plant property and equipment for 1996 (i.e., capital
expenditure)? Find free cash flow for 1996 using the operating definition.
Solution
15. Optimal Trade Capital.

Comment on the following assertion. “If a firm can reduce its trade capital usage, then it
should definitely do so.”
Solution
16. Cash Flow.

ABC has a contribution margin of 20% and fixed costs of $450,000 per annum. Their
corporate tax rate is 40%. For financial statement purposes, ABC takes depreciation charges
on its net fixed assets at the rate of 5% per annum on the declining balance. Capital cost
allowance is the same as financial statement depreciation. As of December 31, 1996, ABC
has financed its business investment with short-term debt and with common equity. ABC
has a trade capital to sales ratio of 12%. This ratio is calculated as trade capital at the end of
the year divided by yearly sales for the associated year (for example trade capital at
December 31, 1996 divided by yearly sales ended December 31, 1996). This ratio is not
expected to change in the foreseeable future. ABC has net fixed assets of $250,000 at
December 31, 1996.
ABC is doing some short term financial planning. They predict sales, for the year ending
December 31, 1997, of $3,000,000. Their invested capital turnover based on this prediction
and December 31, 1996 invested capital is 3.0 (i.e., predicted 1997 sales divided by year-end
1996 invested capital is 3.0). If ABC requires any financing to accommodate their 1997
sales, they plan to increment (or decrement) their short term borrowing. If ABC borrows, or
repays existing short-term debt, they plan to do so at the end of 1997. The interest rate on
short-term debt is 10% per annum. ABC’s predicted 1997 net income is $42,000. ABC
expects to pay no dividends to their shareholders in 1997. ABC expects no capital
expenditures or asset sales in 1997. ABC expects no share repurchases or new share issues
in 1997.
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a) (10 marks) Use 1997 predicted net income to help you determine short-term debt at
December 31, 1996. What is invested capital at December 31, 1996? Calculate ABC’s
predicted 1997 rate return on equity (using beginning of period equity).
b) (10 marks) Does it appear that ABC will need incremental short-term borrowing (at the
end of 1997) or can they pay down some of their short-term debt? What is the most
likely reason for the change in ABC’s debt use?
c) (10 marks) For 1997, calculate ABC’s free cash flow using both the operating and the
financial definitions.
d) (10 marks) Without doing any numerical calculations, do you believe that ABC’s
operating leverage has increased or decreased between 1996 and 1997? Explain.
Solution
17. Free Cash Flow and the Rate of Return on Invested Capital.
1997
Sales ?
Cost of Goods Sold ?
General and Administrative Expenses ?
Interest 35
Depreciation (which equals depreciation for tax) 100
Corporate tax (at 40%) ?
Net Income ?
1996 1997
Accounts Receivable 250 275
Inventory 150 175
Short Term Debt ? 400
Accounts Payable 200 225
Equity ? ?
The following additional financial information is available for ABC:
For both 1996 and 1997, ABC had a trade capital to invested capital ratio of 25% (trade
capital at the end of the year divided by invested capital at the end of the year). ABC has
financed its operations with short-term debt and with common equity. ABC undertakes
borrowing or repayment of debt at the end of the year. Therefore, ABC’s interest charge on
its income statement is equal to outstanding short-term debt at the beginning of 1997 (end of
1996) times the interest rate on this debt which is 7% per annum. Dividends for 1997 are
$95. ABC issued shares for $200 in 1997.
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Required: Based on the information at hand, and the definition(s) of free cash flow
developed in class, find free cash flow for 1997 using both the operating and the financial
definitions. Find ABC’s 1997 rate of return on invested capital, after tax and after
depreciation, using beginning of period invested capital.
Solution
18. Free Cash Flow and the Rate of Return Equity.

1998
Depreciation $30
Interest 10
1997 1998
Trade Capital 150 ?
Short-term Debt ? 250
Net Fixed Assets 300 ?
Equity 350 ?
NOTES: “Equity” is the sum of all of the accounting equity accounts (e.g., share-capital plus
retained earnings). You can presume that depreciation for tax and for financial statement
purposes is the same and, therefore, there is no deferred income tax in this problem.
Any incremental short-term borrowing undertaken by ABC during 1998 was at the end of the
year. Therefore, ABC’s interest expense for 1998 is the interest rate on short-term debt times
short-term debt at the beginning of 1998 (end of 1997). Alternatively, if instead, ABC paid
down any short-term debt during 1998, this was also done at the end of 1998. ABC has
financed its business activity with short-term debt and with common equity. In 1998, ABC’s
rate of return on equity (ROE) was 20%. ROE is calculated with equity at the end of 1998.
ABC paid dividends of $26 during 1998. ABC had no share issues or share repurchases
during 1998. Also in 1998, ABC’s EBITDA margin was 25%. Their trade capital to sales
ratio was 30%, both trade capital and sales are measured at the end of 1998. ABC’s tax rate
is 40%.
Required: Using both the operating and the financial definitions, find ABC’s FCF for 1998.
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Solution
19. Ratios.
Discuss briefly how each of the following five ratios is calculated and what each is intended to
measure:
(a) EBITDA margin,
(b) debt to assets,
(c) times interest earned,
(d) quick ratio (acid test ratio),
(e) asset turnover.
Solution
20. Incremental Business Return

Generally, ABC Company Ltd. has been a non-growing firm. Per annum sales have been
$8,000,000. However, as the result of a favourable international trade agreement between
Canada and the United States, in the upcoming year, sales are expected to increase to
$10,000,000 per annum and remain at this higher level indefinitely into the future.
ABC has a trade capital to sales ratio of 20% and an invested-capital turnover ratio of 1.25.
Trade capital to sales is calculated as trade capital at the beginning of the year divided by
sales for the upcoming year. Invested-capital turnover is calculated as sales for the upcoming
year divided by invested-capital at the beginning of the year. ABC’s depreciation is 5% of
net fixed assets at the beginning of any year. Subsequent to the change in sales, these ratios
and rates are expected to remain unchanged. Depreciation for tax equals financial statement
depreciation. ABC makes maintenance capital expenditures at year-end equal to financial
statement depreciation. Maintenance capital expenditures “maintain” the quality of ABC’s
assets and prevent revenue deterioration.
Generally, other than in the upcoming year, ABC makes no capital expenditures for the
purpose of growth. However, at the beginning of the upcoming year, to accommodate the
increased level of permanent sales, incremental trade capital assets and additional depreciable
assets will be needed. In addition, as the result of the increase in depreciable assets, per
annum year-end maintenance capital expenditures will also increase. Thereafter, because
ABC will be once more a non-growing firm (that is, trade capital will not increase and capital
expenditure for the purpose of growth will again be zero).
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ABC’s contribution margin per dollar sales is 25%. The tax-rate is 40%. Find the rate of
return on ABC’s incremental business investment after tax and after depreciation
(equivalently, after tax and after additional maintenance capital expenditures) arising from
the greater expected level of dollar sales.
Solution
21. Free Cash Flow, Invested Capital, Financial Statements

1999
EBITDA ?
Depreciation ?
Interest ?
1998 1999
Trade Capital ? 200
Short-term Debt ? ?
Equity ? 520
Invested Capital 500 850
NOTES: “Equity” represents the sum of all of the accounting equity accounts (e.g., share-
capital plus retained earnings). You can presume that depreciation for tax and for financial
statement purposes is the same, and therefore, there is no deferred income tax in this problem
.
ABC’s net incremental borrowing for 1999 was $120. Because this borrowing was at the
end of 1999, ABC’s interest expense for 1999 is the interest rate on short-term debt times
short-term debt at the beginning of 1999 (end of 1998). The interest rate on ABC’s short-
term debt is 10% per annum. ABC made net capital expenditures of $365 at the end of 1999.
Because these capital expenditures were at the end of 1999, ABC’s depreciation expense for
1999 (also depreciation for tax) is a rate for depreciation times net fixed assets at the
beginning of 1999 (end of 1998) prior to the capital expenditure. The depreciation rate is
5% per annum. ABC paid dividends to shareholders of $50 during 1999. ABC’s tax rate is
40%. ABC had a free cash flow deficit of $100 for 1999.
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Required: Find ABC’s rate of return on invested capital for 1999, before tax and before
depreciation, using beginning of period invested capital. Was ABC a net seller of common
shares or a net repurchaser of its common shares in 1999?
Solution
22. The Relation Between ROIC and ROE

Today, ABC has invested capital of $4,000,000. Trade capital and net fixed assets are 34% and
66% of invested capital respectively. Invested capital has been financed with short-term debt
and with common equity. The interest rate on short-term debt is 10% per annum. ABC’s tax
rate is 40%. Depreciation is 5% of beginning-of-period net fixed assets. No capital expenditures
are required for the upcoming year. Based on predicted sales in the upcoming year, ABC’s
EBITDA is $1,000,000. Other things equal, ABC’s rate of return on equity (using beginning of
period equity) at predicted sales for the upcoming year, is equal to their predicted rate of return
on invested capital after tax and after depreciation (using beginning of period invested capital)
plus 10%. That is at predicted sales, ROE=ROIC+0.10.
Required: What is ABC’s beginning of period (i.e., today) debt to equity ratio?
Solution
23. The Relation Between ROIC and ROE

2013
EBITDA ?
Depreciation ?
Interest ?
2013
Trade Capital 200
Short-term Debt ?
Equity ?
Invested Capital 1,000
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NOTES: “Equity” represents the sum of all of the accounting equity accounts (e.g., share-capital
plus retained earnings). You can presume that depreciation for tax and for financial statement
purposes is the same, and therefore, there is no deferred income tax in this problem .
ABC neither borrowed incrementally nor repaid short-term debt during 2013, and therefore, its
interest expense for 2013 is the opening balance for 2013 (same as the closing balance) times the
interest rate on its short-term debt, which is 6.25% per annum. ABC’s tax rate is 40%.
ABC’s rate of return on invested capital for 2013, after tax and after depreciation, using end of
period invested capital is 27%. ABC’s ROE for 2013 using end of period book equity is 42.5%.
Required: Find ABC’s debt to equity ratio for 2013.
Solution
24. ROA and ROE.

ABC has return on equity (ROE) of 24 percent and a return on assets (ROA) of 16%.
Required: Find ABC’s debt to equity ratio.
Solution
25. Relation Between ROIC and ROE

2013
EBITDA ?
Depreciation ?
Interest ?
2013
Trade Capital ?
Short-term Debt 400
Equity ?
Invested Capital ?
2-73
NOTES: “Equity” represents the sum of all of the accounting equity accounts (e.g., share-
statement purposes is the same, and therefore, there is no deferred income tax in this
problem .
The interest rate on ABC’s short-term debt is 8% per annum. ABC’s tax rate is 40%.
ABC’s rate of return on equity (ROE) for 2013 using end of period book equity is 16.8%.
Their rate of return on invested capital for 2013, after tax and after depreciation, using end
of period invested capital, is 12%.
Required: Find ABC’s 2013 year-end invested capital.
Solution
26. ROA, ROE, and Net Profit Margin

ABC company limited has a 4 percent net profit margin, a return on equity (ROE) of 32 percent,
a return on assets (ROA) of 16 percent.
Required:
(a) Find ABC’s asset turnover ratio.
(b) Find ABC’s debt to equity ratio.
Solution
2-74
27. ROIC and ROE
2008
EBITDA 400
Depreciation 25
Interest ?
2008
Trade Capital ?
Short-term Debt ?
Net Fixed Assets ?
Equity 600
Invested Capital ?
interest rate on its short-term debt, which is 8% per annum. ABC’s tax rate is 40%.
ABC’s rate of return on invested capital for 2008, after tax and after depreciation, using end of
period invested capital equals its 2008 ROE using end of period equity.
Required: Find ABC’s 2008 interest expense (in dollars).
Solution
28. ROIC Versus ROE

2008
EBITDA 600
Depreciation 40
Interest
2008
Trade Capital ?
Short-term Debt ?
Net Fixed Assets ?
Equity ?
Invested Capital ?
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The interest rate on ABC’s short-term debt is 9% per annum. ABC paid down no debt during
2008, and therefore, their opening debt balance for 2008 equals their closing 2008 debt balance.
ABC’s tax rate is 40%.
ABC’s rate of return on equity (ROE) for 2008 using end of period book equity is 20%. Their
year-end 2008 debt to invested capital ratio is 25%.
Required: Find ABC’s 2008 Invested Capital.
Solution
29. ROIC
Comment on the following assertion. “A primary determinant of a firm’s rate of return on
invested capital (after tax and after depreciation) is corporate debt use.” Use no numerical
examples in your response. A complete response is required for full marks.
Solution
30. ROIC Versus ROE

2008
EBITDA 700
Depreciation 520
Interest 100
2008
Trade Capital ?
Short-term Debt ?
Net Fixed Assets ?
Equity ?
Invested Capital ?
2-76
ABC paid down no debt during 2008, and therefore, their opening debt balance for 2008 equals
their closing 2008 debt balance. ABC’s tax rate is 40%. ABC’s 2008 rate of return on equity
(with 2008 year-end book equity) equals their 2008 rate of return on invested capital (after tax,
after depreciation, with 2008 year-end invested capital).
Required: Find ABC’s year-end 2008 equity to invested capital ratio (2008 year-end equity
divided by 2008 year-end invested capital).
Solution
31. ROIC Versus ROE

2008
EBITDA ?
Depreciation 400
Interest ?
2008
Trade Capital ?
Short-term Debt 900
Net Fixed Assets ?
Equity ?
Invested Capital ?
interest rate on its short-term debt, which is 10% per annum. ABC’s tax rate is 40%. ABC’s rate
of return on invested capital for 2008, after tax and after depreciation, using end of period
invested capital is 20%. ABC’s 2008 ROE using end of period equity is 26%.
2-77
Required:
(a) Find ABC’s 2008 year-end Invested Capital.
(b) Find ABC’s 2008 EBITDA.
Solution
32. ROIC Versus ROE

Comment on the following assertion. “When a firm does well on its business investments,
that is, EBITDA is high, the rate of return on invested capital (ROIC) is correspondingly high
and exceeds the rate of return on equity (ROE). On the other hand, when a firm does poorly
on its business investments, ROIC is low and is below ROE.” State whether or not you agree
with the assertion and then explain why. Use no numerical examples in your response. A
complete response is required for full marks.
Solution
33. Free Cash Flow

1999
EBITDA ?
Depreciation 20
Interest 25
1998 1999
Trade Capital ? ?
Short-term Debt ? 300
Equity 520 ?
Invested Capital ? 850
ABC’s did some incremental borrowing during 1999. Because this borrowing was at the end of
1999, ABC’s interest expense for 1999 is the interest rate on short-term debt times short-term
2-78
debt at the beginning of 1999 (end of 1998). The interest rate on ABC’s short-term debt is 10%
per annum. ABC made net capital expenditures (e.g. net of disposals) of $165 at the end of
1999. Because these capital expenditures were at the end of 1999, ABC’s depreciation expense
for 1999 (also depreciation for tax) is a rate for depreciation times net fixed assets at the
beginning of 1999 (end of 1998) prior to the capital expenditure. The depreciation rate is 5%
per annum. ABC paid dividends to shareholders of $50 during 1999. ABC’s tax rate is 40%.
ABC had a free cash flow surplus of $100 for 1999.
Required: Find ABC’s rate of return on invested capital for 1999, after tax and after
depreciation, using beginning of period invested capital. Was ABC a net purchaser or seller of
its own common shares in 1999? What was is the amount of shares sold or repurchased?
Solution
34. Free Cash Flow

1999
EBITDA ?
Depreciation ?
Interest 25
1998 1999
Trade Capital 180 200
Short-term Debt ? ?
Equity ? 520
Invested Capital 850 ?
ABC’s did some incremental borrowing during 1999. Because this borrowing was at the end of
1999, ABC’s interest expense for 1999 is the interest rate on short-term debt times short-term
debt at the beginning of 1999 (end of 1998). The interest rate on ABC’s short-term debt is 8%
per annum. ABC made net capital expenditures (e.g. net of disposals) of $365 at the end of
1999. Because these capital expenditures were at the end of 1999, ABC’s depreciation expense
for 1999 (also depreciation for tax) is a rate for depreciation times net fixed assets at the
beginning of 1999 (end of 1998) prior to the capital expenditure. The depreciation rate is 5%
per annum. ABC paid dividends to shareholders of $50 during 1999. ABC’s tax rate is 40%.
ABC had a free cash flow deficit of $100 for 1999.
2-79
Required: Find ABC’s rate of return on invested capital for 1999, after tax and after
depreciation, using beginning of period invested capital. Was ABC a net seller of its common
shares or a net purchaser of its common shares in 1999? What is the dollar amount of shares
sold or repurchased?
Solution
35. Free Cash Flow

2003
EBITDA 450
Depreciation ?
Interest ?
2002 2003
Trade Capital 550 ?
Short-Term Debt ? ?
Equity 800
Invested Capital ? ?
NOTES: "Equity" represents the sum of all of the accounting equity accounts (that is, share-
statement purposes is the same, and therefore, there is no deferred income tax or future income
tax liability in this problem .
ABC repaid $200 of their short-term debt at year-end 2003. Therefore, ABC's 2003 interest
expense is the interest rate on short-term debt times short-term debt at the beginning of 2003
(year-end 2002). The interest rate on ABC's short-term debt is 8% per annum. ABC made
capital expenditures of $365 at year-end 2003. Because these capital expenditures were at year-
end, ABC’s 2003 depreciation expense (also depreciation for tax) is a rate for depreciation times
Net Fixed Assets at the beginning of 2003 (year-end 2002). The depreciation rate is 5% per
annum. ABC paid dividends to shareholders of $X during 2003. ABC's tax rate is 40%. Also,
during 2003, ABC sold new shares to new shareholders in the amount of $125 (no shares were
repurchased). ABC’s 2003 free cash flow was $253.
2-80
Required: How much did ABC pay in dividends (in total rather than per share) to shareholders
during 2003?
Solution
36. Free Cash Flow

2003
EBITDA 450
Depreciation ?
Interest ?
2002 2003
Trade Capital ? ?
Short-Term Debt ? ?
Net Fixed Assets 300 630
Equity 517 700
Invested Capital ?
ABC's 2003 interest expense is the interest rate on short-term debt times short-term debt at the
beginning of 2003 (year-end 2002). The interest rate on ABC's short-term debt is 8% per annum.
ABC made capital expenditures of $365 at year-end 2003. Because these capital expenditures
were at year-end, ABC’s 2003 depreciation expense (also depreciation for tax) is a rate for
depreciation times Net Fixed Assets at the beginning of 2003 (year-end 2002). ABC paid
dividends to shareholders of $50 during 2003. ABC's tax rate is 40%. Also, during 2003, ABC
sold new shares to new shareholders in the amount of $100 (no shares were repurchased).
ABC’s 2003 free cash flow was $253.
Required: Determine the amount of ABC’s short-term debt repayment or the increment to
short-term debt borrowing at year-end 2003.
Solution
2-81
37. Free Cash Flow
2008
EBITDA ?
Depreciation ?
Interest 35
2013 2008
Trade Capital 650 ?
Short-Term Debt ? ?
Equity 900
ABC repaid $200 of their short-term debt at year-end 2008. The interest rate on ABC’s debt is
10% per annum. ABC made capital expenditures of $385 at year-end 2008. Because these
capital expenditures were at year-end, ABC’s 2008 depreciation expense (also depreciation for
tax) is a rate for depreciation times Net Fixed Assets at the beginning of 2008 (year-end 2013).
The depreciation rate is 5% per annum. ABC paid dividends to shareholders of $X during 2008.
ABC's tax rate is 40%. Also, during 2008, ABC sold new shares to new shareholders in the
amount of $125 (no shares were repurchased). ABC’s 2008 free cash flow was $353.
Required:
(a) Determine ABC’s 2008 dividend payment, $X.
(b) Determine ABC’s 2008 rate of return on invested capital, after tax and after depreciation,
using beginning of period invested capital.
Solution
38. Free Cash Flow

2008
EBITDA ?
Depreciation ?
Interest ?
2-82
2013 2008
Trade Capital 845
Short-Term Debt 540 480
Net Fixed Assets 640 ?
Equity ? ?
ABC repaid some of their short-term debt at year-end 2008. The interest rate on ABC’s debt is
10% per annum. ABC made capital expenditures of $105 at year-end 2008. Because these
capital expenditures were at year-end, ABC’s 2008 depreciation expense (also depreciation for
tax) is a rate for depreciation times Net Fixed Assets at the beginning of 2008 (year-end 2013).
The depreciation rate is 5% per annum. ABC paid dividends to shareholders of $55 during 2008
(in total rather than per share). ABC's tax rate is 40%. ABC’s 2008 free cash flow was $283.
Required: Determine ABC’s 2008 rate of return on invested capital after tax and after
depreciation using beginning of period invested capital.
Solution
39. ROIC and ROE:

The following information is available on the financial accounts of ABC Ltd.
2006
EBITDA 400
Depreciation 40
Interest 60
2-83
2006
Trade Capital 200
Short-term Debt 600
Equity 400
Invested Capital ?
The interest rate on ABC’s short-term debt is 10% per annum. ABC’s tax rate is 40%.
a). Find ABC’s rate of return on invested capital for 2006, after tax and after depreciation, using
end of period invested capital.
b). Find ABC’s ROE for 2006 using end of period book equity.
c). Show that the ROIC from part “a” of this question can also be calculated as the after
corporate tax interest rate on debt times the debt to invested capital ratio plus the ROE from part
“b” of this question times the equity to invested capital ratio. That is:
Debt Equity
ROIC  (1  t ) * r *  ROE * ,
Invested Capital Invested Capital
where “r” is the interest rate on debt and “t” is the corporate tax rate. This relation says that the
firm’s ROIC, the rate of return that the firm earns for all financial asset-holders, is a weighted
average of the rates of return that the firm earns for the specific financial asset-holders (in this
problem, the creditors and the common shareholders).
Solution
40. A Benchmark for ROIC and ROE

ABC Company has debt and common equity in its financial structure. The interest rate on ABC
Company’s debt is 10% per annum. The corporate tax rate is 40%. In 2006, ABC’s ROIC (after
tax and after depreciation) equals ROE. For 2006 what was ABC’s ROIC?
Solution
2-84
(2.11) Chapter Index
Previous Section Table Contents
accounts payable deferral period, 42 industry averages, 7

accounts payable turnover, 41 inventory conversion period, 41
accounts receivable collection period, 41 inventory turnover, 41
accounts receivable turnover, 41 invested capital, 12, 15, 16
business investments, 15 invested capital balance sheet, 16
capital expenditure, 31, 33 Liquidity, 40
capital intensity, 29 maximization of shareholders’ wealth, 21
cash conversion cycle, 42 maximize shareholder wealth, 7
COMPUSTAT, 10 net fixed assets, 16
current assets, 15 Net fixed assets, 16
current liabilities, 15 net working capital, 15
current ratio, 40 operating definition of invested capital, 15
debt to invested capital, 25 opportunity cost returns, 6
dividends, 37 quick ratio, 41
EBITDA, 28 rate of return on equity, 6, 21
EBITDA margin, 28, 30 rate of return on invested capital, 19, 43
financial analysis, 11 Research Insight, 10
financial definition of FCF, 35 share repurchase, 37
financial ratios, 11 Standard and Poor’s Corporation, 10
financial statement analysis, 8 the rate of return on invested capital, 6
free cash flow, 31 trade capital, 15, 31, 43
Funds from operations, 32 Trade capital, 15
2-85

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Introduction

Limitations of Ratios: 36 minutes

Industry comparison is a narrow perspective on corporate benchmarking. Remember that the

(2.3) A Spreadsheet Template for Financial Analysis

2.4.1 The Financial Definition of Invested Capital

LT Debt and other LT Liabilities $11,604 + $1,131

Other Financial Assets 0

Invested Capital in the Financial

2.4.2 The Operating Definition of Invested Capital

2.4.3 The Invested Capital Balance Sheet

Next Section Previous Subsection Table Contents

Debt 6,694 8,443 8,562 8,761 10,683 13,259 14,162 15,099

ROIC (BOP) 0.092 0.090 0.088 0.094 0.087 0.071 0.078

(2.5) Business Returns

(1−𝑡)∗(𝐸𝐵𝐼𝑇𝐷𝐴+ 𝑜𝑡ℎ𝑒𝑟 𝑖𝑛𝑐𝑜𝑚𝑒 − 𝑑𝑒𝑝𝑟𝑒𝑐)

Sales (Net) 11,927.000 12,430.000 12,725.000 13,202.000

STATEMENT OF RETAINED EARNINGS

2.5.2 Industry ROIC

Next Subsection Previous Subsection Table Contents

ROIC After Tax and After Depreciation for

2.5.3 The Rate of Return on Equity (ROE)

If the primary objective of managers is to maximize shareholders’ wealth, then an important

ROE for 360 US and Canadian Industries

2.5.4 The Relation Between ROIC and ROE

The Relation Between ROIC and ROE: 19 Minutes

and, second, as the right of,

2.5.5 Why are ROIC and ROE both IRRs?

For this typical business investment, NPV is,

2.5.6 Components of ROIC

EBITDA Margin: 18 Minutes

for TELUS in 2017.

The EBITDA margin is a measure of operating efficiency. It measures the fraction of $1 of

Industry EBITDA Margins for 2016

The 2017 invested capital turnover ratio for TELUS is $13,202/24,186=0.546.

IC-Turnover for 432 US and Canadian Industries 2000 to 2016

ROIC = EBITDA Margin  Invested Capital Turnover

(2.6) Free Cash Flow

Free Cash Flow = FFO - Incremental Investment

FFO is the “benefit” of past business investment.

FFO = 1,460 +2,182+566*(1-0.272) = $4,054 (in $US millions)

∆𝑇𝐶 = 𝑇𝐶𝐸𝑂𝑃 − 𝑇𝐶𝐵𝑂𝑃 = 𝑇𝐶17 − 𝑇𝐶16=-802-(-1,050)=$248 ($US millions)

Incremental short-term business investment for TELUS in 2017 is $248.

We can rearrange an accounting calculation to determine CAPX.

NFAEOP  NFABOP  CAPX  deprec .

CAPX  NFA  deprec

𝐶𝐴𝑃𝑋17 =26,622-25,236+2,182 = $3,568 ($US millions)

FCF  FFO  TC  CAPX

For TELUS for 2017,

𝐹𝐶𝐹17 = $4,054 - $248 - $3,568 = $238 ($US millions)

FCF Deficit/Surplus: 7 Minutes

Firms with a FCF Deficit Have the Following Common Characteristics

1. Growth Oriented with Large Business Investments

2. New Ventures that have Not Yet Completed Business

Free Cash Flow =

After Corporate Tax Net Distributions to Debt-holders

Net Distributions to Shareholders

2.6.3 After Tax Distributions to Creditors

FCFFIN Creditors: 7 Minutes

After Tax Cost of Dollar Interest  566*(1-0.272) = $412