Asset and Value: Cash Determination Principle

• An asset has a value ( or market price)

Topic 1 because it has the capacity to generate future
Free Cash Flows, Cost of Capital, cash flows.
and Valuation • It is the future cash flows that determine the
value of the asset.
Chapter 2, 5, 6, 7, 9 • The principle is equally applied in both real
assets and financial assets.

Discounted Cash Flow (DCF) model What determines the discount rate?
• To value a future cash flow, it must be discounted to • Two factors determine the discount rate
the present, and so we have the discounted cash applied in a certain asset:
flow (DCF) model.
– Market risk free rate, which is determined by
• PV of a simple cash flow Ct: V = Ct /(1+r)t general market economic condition.
• Two parameters to determine the value: – Risk premium, unique to the underlying asset
– Its average level of cash flows, used in the numerator, Ct which is determined by the risk degree of the
– The risk level of the cash flow, determining the corresponding cash flow.
appropriate discount rate, r
• So the discount rate 𝑟𝑖,𝑡 = 𝑟𝑅𝐹𝑡 + 𝑅𝑃𝑖,𝑡
 Determinants of Intrinsic Value: Calculating FCF
Sales revenues
Mini Case: Computron
− Operating costs and taxes

− Required investments in operating capital Jenny Cochran, a graduate of The University of Tennessee with 4
years of experience as an equities analyst, was recently brought
Free cash flow in as assistant to the chairman of the board of Computron
=
(FCF)
Industries, a manufacturer of computer components.
FCF1 FCF2 FCF∞
During the previous year, Computron had doubled its plant
Value = + + ... + capacity, opened new sales offices outside its home territory,
(1 + WACC) (1 + WACC)
1 2 (1 + WACC)∞
and launched an expensive advertising campaign. Cochran was
assigned to evaluate the impact of the changes. She began by
Weighted average
cost of capital gathering financial statements and other data.
(WACC)

Market interest rates Cost of debt Firm’s debt/equity mix

Market risk aversion Cost of equity Firm’s business risk

17 18

Computron's Balance Sheets (Millions of

Dollars)
2018 2019
Assets
Cash and equivalents $ 60 $ 50
Computron's Income Statement (Millions of Dollars) Short-term investments 100 10
2018 2019 Accounts receivable 400 520
Inventories 620 820
Net sales $ 5,500 $ 6,000
Total current assets $ 1,180 $ 1,400
Cost of goods sold (Excluding depr. & Gross fixed assets $ 3,900 $ 4,820
amort.) 4,300 4,800 Less: Accumulated depreciation 1,000 1,320
Depreciation and amortizationa 290 320 Net fixed assets $ 2,900 $ 3,500
Other operating expenses 350 420 Total assets $ 4,080 $ 4,900
Total operating costs $ 4,940 $ 5,540
Liabilities and equity
Earnings before interest and taxes (EBIT) $ 560 $ 460 Accounts payable $ 300 $ 400
Less interest 68 108 Notes payable 50 250
Pre-tax earnings $ 492 $ 352 Accruals 200 240
Total current liabilities $ 550 $ 890
Taxes (25%) 123 88
Long-term bonds 800 1,100
Net Income $ 369 $ 264 Total liabilities $ 1,350 $ 1,990
Common stock 1,000 1,000
Notes: Retained earnings 1,730 1,910
a Computron has no amortization charges. Total equity $ 2,730 $ 2,910
Total liabilities and equity $ 4,080 $ 4,900
19 20
 Transforming B/S from Accounting Version to
Finance Version
• Step 1: identify items • Step 2: rearrange items
A natural consequence of operations  operating
A discretionary choice of financing or investment Assets Liabilities and Equity
(i.e. pay /receive interests)  non-operating
Operating current assets (OpCA) S-T Debt (STD)
– Operating S-T liabilities (OpSTL) L-T debt (LTD)
Assets Liabilities and Equity Other L-T assets (OLTA)
Equity (E)
– Operating L-T liabilities (OpLTL)
Operating current assets (OpCA) Operating S-T liabilities (OpSTL)
Short term investments (STI) S-T Debt (STD) Net operating L-T assets (NFA)
Net operating L-T assets (NOpFA, or NFA) Operating L-T liabilities (OpLTL)
Other L-T assets (OLTA) L-T debt (LTD) Short term investments (STI)
Long term investments (LTI) Long term investments (LTI)
Equity (E)
21 23

[Example] Transform Computron’s B/S to simplified finance

• Step 3: combine items version for 2019.

Assets Liabilities and Equity Assets Liabilities and Equity

OpCA = 50 + 520 + 820 = 1,390 OpSTL = 400 + 240 = 640
Working capital (WC) S-T Debt (STD) NFA = 3,500 STD = 250
+ Net operating L-T assets (NFA) + L-T debt (LTD) STI = 10 LTD = 1,100
Equity (E) E = 2,910
Short term investments (STI)
+ Long term investments (LTI)
Assets Liabilities and Equity
WC = OpCA – OpSTL = 1390 – 640 = 750 STD = 250
NFA = 3,500 LTD = 1,100
STI = 10 E = 2,910
Assets Liabilities and Equity
Assets Liabilities and Equity
Net operating assets (NOA) Debt (D) NOA = WC + NFA = 750 + 3,500 = 4,250 D = STD + LTD = 250 + 1,100 =
INV = 10 1,350
Equity (E)
Investments (INV) E = 2,910
24 25
 Computron's Statement of Cash Flows (Millions of Dollars)
2019
Statement of Cash Flows Operating Activities
Net Income before preferred dividends $ 264
Non cash adjustments
Depreciation and amortization 320
NOA + INV = D + E Due to changes in working capital
ΔNOA + ΔINV = ΔD + ΔE Change in accounts receivable (120)
Change in inventories (200)
Change in accounts payable 100
Change in accruals 40
ΔCash = ΔD + ΔE – ΔNOA – ΔINV Net cash provided by operating activities $ 404
= ΔD + ΔE – (ΔWC + ΔNFA) – ΔINV Investing activities
= ΔD + (Net E Issue + NI – Div) – (ΔWC + ΔNFA) – ΔINV Cash used to acquire fixed assets $ (920)
Change in short-term investments 90
= [NI – ΔWC] + [ΔNFA – ΔINV] + [ΔD + (Net E Issue – Div)] Net cash provided by investing activities $ (830)
= [Operating activities] + [Investing activities] + [Financing Financing Activities
activities] Change in notes payable $ 200
Change in long-term debt 300
Payment of cash dividends (84)
Net cash provided by financing activities $ 416

Net change in cash and equivalents $ (10) = 404 + (-830) + 416

Cash and securities at beginning of the year 60
Cash and securities at end of the year $ 50
26 27

Free Cash Flows Calculating Free Cash Flow in 5 Easy Steps

• FCF is the amount of cash available from operations for
distribution to all investors after making the necessary
investments to support operations.
• A company’s value depends upon the amount of FCF it
can generate.
• Five uses of FCF are:
1) Pay interest on debts.
2) Pay back principal on debt.
3) Pay dividends.
4) Buy back shares.
5) Buy nonoperating assets (e.g. marketable securities,
investments in other companies, etc.)
A better measure for true operation A natural consequence of operations  operating
performance (profit generated if it had A discretionary choice of financing or investment
no debt and no financial assets) (i.e. pay /receive interests)  non-operating
Note: EBIT from operations
Operating CA: ST assets used in
operating activities, e.g. cash,
inventory, A/R
(exclude ST investment)

Operating CL: ST liabilities arise in the

normal course of operations, e.g. A/P,
accruals
(exclude N/P)

30 31

Net FA or LTA,
e.g. net plant, Cash available from
“operating capital”, equipment
operation
”capital”

[Alternatively based on source of funds]

Total investor-supplied capital
= N/P + LTD + preferred stock + common equity – ST investments

Investments (in WC and FA)

33 necessary to sustain operation 34
 Computron’s FCF Computron’s FCF (cont.)
Step 1: NOPAT Step 3: operating capital
NOPAT = EBIT(1 – tax) operating capital = NOWC + net FA
NOPAT (current) = 460(1 – 0.25) = $345 operating capital (current) = 750 + 3500 = $4250
operating capital (previous) = $3480
Step 2: NOWC
NOWC = operating CA – operating CL Step 4: net investment in operating capital
NOWC (current) = (50 + 520 + 820) – (400 + 240) = $750 Net investment in operating capital = operating
NOWC (previous) = $580 capital (current) – operating capital (previous)
= 4250 – 3480 = $770

35 36

Computron’s FCF (cont.) Performance Evaluation

Step 5: FCF
• Return on investment capital (ROIC)
FCF = NOPAT – net investment in capital
– ROIC = NOPAT/operating capital
= 345 – 770 = -$425
– Adding value if ROIC > WACC
Check Statement of CF Profitability
Uses of FCF: • Operating profitability ratio (OP) measurement
After-tax interest payment = 108×(1-0.25) = $81 – OP = NOPAT/sales
Capital utilisation
Decrease (increase) in debt = (‒200) + (‒300) = ‒500 • Capital requirement ratio (CR) measurement
Payment of dividends = 84 – CR = total net operating capital/sales
Repurchase (issue) stock =0 • ROIC (NOPAT/OpCap) =
Purchase (sale) of ST = (‒90)
(NOPAT/sales)(sales/OpCap) = OP/CR
investments
= ‒$425 37 38
 Performance Evaluation (cont.) Performance Evaluation (cont.)
• Market value added (MVA) • Economic value added (EVA)
– MVA = MV of stock – equity capital supplied by – EVA = NOPAT – after-tax dollar cost of capital used
shareholders = (shares outstanding)(stock price) – to support operation = NOPAT – (operating
total common equity capital)(WACC)
– EVA = (operating capital)(ROIC – WACC)
– MVA = total MV – total investor-supplied capital =
(MV of equity+ MV of debt) – (BV of equity + BV of – Measure the residual income after the cost of all
capital.
debt) Usually assume MVD = BVD, – Measure value added in a given year so a better
then MVA = MVE – BVE measurement for managerial effectiveness and/or
– Measure value added over company’s entire life. individual division.

39 40

Determinants of Intrinsic Value:

The Weighted Average Cost of Capital
Capital Components
• Capital components are sources of funding
that come from investors used to pay for long-
term assets.
• Usually include long-term debt, preferred
stock, and common equity.
– Permanent short-term debt should be included.
– A/P, accruals, and deferred taxes are not sources
of funding and should not be included.
OpCL is adjusted when
calculating the CFs of a project.
 Notes on Costs of Capitals Weight Cost of Capital (WACC)
• After-tax • Weighted average of the after-tax component
• New (marginal) rather than historical costs of capital
(embedded) • WACC = rd(1 – T)wd + rstd(1 – T)wstd + rpswps +
• Be forward looking rsws
• Be market determined – rd, rstd, rps, rs: require rate of return on LTD, STD,
• Reflect the opportunity cost of capital of preferred stock, and common stock, respectively.
investment – wd, wstd, wps, ws: weights of LTD, STD, preferred
• Reflect the risks associated with the stock, and common stock, respectively.
investment – T: firm’s effective marginal tax rate.
Source: Vignaroli (2021)
45

Cost of Debt
• Long-term debt
– Coupon on the new LTD issued by the firm, or
– Yield to maturity on existing debt (or other bonds with
a similar rating).
• Short-term debt (permeant)
– Interest rate being charged.
• Notes:
– Use after tax cost as interest is tax deductible: rd AT =
rd BT(1 – T) To be consistent with occurrence
– Use nominal rate. of capital budgeting CFs.
– Flotation costs are small and can be ignore.