1

Capital

Part 1

Capital 2016

Topics• Invested capital• Return to invested capital• Cash flow to invested capital• Capital structure• Cost of capital• Economic profit

2Capital 2016

3

Primary Objectives

Invested capital

IC = NFA + NWC

IC: book value of invested capitalNFA: Net fixed assets NWC: Net working capital Start with Fairway

Corp but then assume that invested securities, IS, non-operating cash, and deferred taxes, T, are all zero Capital 2016

4

Primary Objectives

Return to invested capital

NOPAT = EBIT·(1 – t) + DT

NOPAT: Net operating profit after taxEBIT: Earnings before interest and tax t: Average tax rateT: Deferred tax

Rate of return on invested capital

Capital 2016

5

Primary Objectives

Cash flow to invested capital

FCF = NOPAT – DIC = NOPAT – DNFA – DNWC

FCF: Free cash flow

k: weighted average cost of capitalV: value of the firm

Capital 2016

6

Primary Objectives

Capital 2016

Economic profit

EP = return on invested capital – cost of invested capital

=( roic – k ) ∙ IC

k: weighted average cost of capitalroic: rate of return on invested capitalIC: book value of the invested capital

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Balance Sheet

Capital 2016

8

Accounting Principles and Guidelines

1. Economic Entity Assumption2. Monetary Unit Assumption

Economic activity is measured in U.S. dollars, and only transactions that can be expressed in U.S. dollars are recorded.

Because of this basic accounting principle, it is assumed that the dollar's purchasing power has not changed over time. As a result accountants ignore the effect of inflation on recorded amounts. 3. Time Period Assumption4. Cost Principle5. Full Disclosure Principle6. Going Concern Principle7. Matching Principle8. Revenue Recognition Principle9. Materiality10. Conservatism

Capital 2016

9

Balance Sheet Overview

Liabilities

Non-interest bearing

Debt

Equity

Assets

Cash

OtherCapital

Capital 2016

Balance Sheet

10Capital 2016

Balance Sheet NotationAccounting periods span a period Dt

Dt = ti – ti-1

An account X has value Xi at time ti and value Xi-1 at time ti-1

The change in account value over Dt is DX, DX= Xi - Xi-1

11

i-1 i i+1 ti-1 Dt ti ti+1

Xi-1 DX Xi Xi+1

Capital 2016

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Balance Sheet

Capital 2016

Property, Plant, & EquipmentGFAi PPE or gross fixed assets (total cost) at time ti

CX capital expense (“capex”) over ∆t

CG gross cost of PPE sold off over ∆t

GFAi = GFAi-1 + CX – CG

DGFA = CX - CG ti-1

GFAi-1

ti

GFAi

DtCXCG

13Capital 2016

Property, Plant, & EquipmentADi accumulated depreciation on PPE at time ti

DX depreciation expense over ∆tCC book value (carry cost) of PPE sold off over ∆tCG gross cost of PPE sold off over ∆t ADi = ADi-1 + DX – (CG – CC)

CG – CC: Gross cost – carry cost of PPE sold off over DtAccumulated depreciation of PPE sold off over Dt

DAD = DX – CG + CC

Accounting income on the sale of PPE over Dt is

DG = CS – CC CS is cash received on sale of PPE

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ti-1

ADi-1

ti

ADi

DtDX

CG-CC

Capital 2016

Property, Plant, & Equipment

GFAi gross fixed asset (total cost) capital investment at time ti

ADi accumulated depreciation on PPE at time ti

NFAi Net fixed assets (PPE) at time ti

NFAi = GFAi - ADi ∆NFA = DGFA – DAD

= (CX – CG) – (DX – CG + CC)= CX – DX - CC

15

ti-1

NFAi-1

ti

NFAi

DtCX

DX+CC

Capital 2016

Invested CapitalWorking Capital

WC = CA – CL= CE + AR + INV – AP – ITP – SD

Net Working Capital (net of cash and short term debt)

NWC = AR + INV – AP – ITP

DNWC = DAR + DINV – DAP –D ITP

Invested Capital

IC = NFA + NWC

∆IC = ∆NFA + ∆NWC

= CX – DX – CC + ∆NWC

Also called net operating assets 16Capital 2016

Invested Capital∆IC = ∆NFA + ∆NWC

= CX – DX – CC + ∆NWC

If only fully depreciated assets are sold during the period, then CC= 0, thus

∆IC = CX – DX + ∆NWC

In a steady state operating approximation, CX = DX and ∆NWC = 0, thus

∆IC = 0

17Capital 2016

18

Very Simple Balance Sheet

Start with Fairway Corp but then assume that invested securities, IS, non-operating cash, and deferred taxes, T, are all zero

Capital 2016

Income Statement

19

DG=CS-CC=$20,000-$0

Capital 2016

20

NP: Net profitEBIT: Earnings before interest and taxesIX: Interest expenseIT: Income tax expense, t average income tax rate NP = EBIT – IX – IT

IT = t ·(EBIT – IX) = t ·EBIT – t · IXNP = EBIT – IX – t ·EBIT +t · IXNP = EBIT(1 – t) – IX(1 – t)

= (EBIT– IX)∙(1 – t)

Net Profit: Return To Equity

Capital 2016

Return on Invested CapitalNP = (EBIT-IX)·(1 – t) = EBIT·(1 – t) - IX·(1 – t) Adjust NP to return to invested capital, NOPATo Effective interest, IX∙(1-t), had been subtracted out of NP,

so add it backo Non-operating effective income such as interest and

dividends received, IDI∙(1-t), had been added in, so subtract it out

o Deferred taxes, DT, had been subtracted out with ITX, so add it back since it accrues to capital

NOPAT = EBIT·(1 – t) – IX·(1 – t) + IX∙(1-t) - IDI∙(1-t) +DT = (EBIT– IDI) ·(1 – t) +DT

NOPAT is Net Operating Profit After Tax21Capital 2016

Return on Invested Capital

NOPAT = (EBIT– IDI) ·(1 – t) + DT

If no deferred tax increment, DT =0, and no investment income from non-operating assets, IDI = 0 e.g., say the investment securities, IS, had paid no dividends

Then

NOPAT= EBIT· (1 – t)

22Capital 2016

23

Income Taxes

Income taxed paid out (ITC)

Income taxes payable (ITP)

Income taxes deferred (T)

Income tax expense (ITX)

Capital 2016

Profitability Ratios• Profit margin

o a measure of revenue productivityo how much net profit, NP, is generated from $1 of revenue,

R?

24Capital 2016

Profitability Ratios• Return (rate) on assets, roa

o a measure of asset productivityo how much net profit, NP,

is generated from $1 of total book value of assets, TA?

25Capital 2016

Profitability Ratios• Return (rate) on equity, roe

o a measure of equity productivityo how much net profit, NP, is generated from $1 of total book

equity, EB?

26Capital 2016

Profitability RatiosThe DuPont formula defines roe as a product of three ratios to provide insight into 3 aspects of the firm

: net profit margin - How much net profit is produced per $1 of revenue?

: asset productivity relative to revenue - How much revenue is produced per $1 of total assets?

: measure of financial leverage - What is the dollar value of firm assets per $1 of equity? 27Capital 2016

Profitability Ratios

net profit margin - How much net profit is produced per $1 of revenue?

asset productivity relative to revenue - How much revenue is produced per $1 of total assets?

measure of financial leverage - What is the dollar value of firm assets per $1 of equity?

28Capital 2016

Profitability Ratios• Return (rate) on invested capital, roic

o a measure of capital productivityo how much return, NOPAT, is generated from $1 of invested

capital, IC ?

29Capital 2016

30

Corporate Finance Decisions

roic k >

Capital 2016

Interest Coverage Ratios

31Capital 2016

Ratios• Balance sheet denominators might be defined as

averages• Example roe

32Capital 2016

33

Capital

Part 2

Capital 2016

34

Cash Flows in a Company

AssetsRevenue generating economic resources

‘Invest’ capital in assets

CapitalDebt

Equity

Raise capital

Return capital

Return to retained earnings Operating income

EBIT

Interest expense to banks and

bondholdersIX

Income tax expense

ITX

Dividends to shareholders

DIV

34Capital 2016

Statement of Cash Flows

35Capital 2016

Cash Flows

36

Net cash from operating activities

Net cash frominvesting activities

Net cash from financing activities

CFO

CFI

CFF

∆CE = CFO + CFI + CFF

Liabilities

Non-interest bearing

Interest bearing

Deferred tax

Equity

Retained Earnings

Common stock

Assets

Cash & equiv

Capital 2016

Cash Flows

37

Net cash from operating activities

Net cash used by investing activities

Net cash from financing activities

Liabilities

Non-interest bearing

Debt

Deferred tax

Equity

Retained Earnings

Common stock

Dividends paid out

Interest paid out

Assets

Cash & equivFCF

CFO *

CFI*

*Modified to remove effects of non-operating cash flows and to include effective interest to debt holders

Capital 2016

Free Cash Flow FCF = CFO* + CFI*

CFO = NP + DX + ∆T –DNWC - DG

CFO* = CFO - IDI∙(1-t) + IX∙(1-t)

= NP + DX + ∆T –DNWC - DG - -IDI∙(1-t) + IX∙(1-t)

= EBIT ·(1 – t) – IX·(1 – t) + DX + ∆T - ∆NWC – DG

-IDI∙(1-t) + IX∙(1-t) -

= (EBIT – IDI)·(1 – t) + ∆T + DX - ∆NWC – DG

= NOPAT + DX - ∆NWC – DG

38

At Fairway Corp• All IDI and IX transactions

are cash not accrual• IS is a non-operating asset

CFI = -CX + DIS + CS

CFI* = CFI – DIS= -CX + DIS + CS – DIS = - CX + CS

Capital 2016

Free Cash Flow FCF = CFO* + CFI*

FCF = NOPAT + DX - ∆NWC – DG - CX + CS

-DG = -CS + CC (from slide 14)

FCF = NOPAT – DNWC – CX + DX + CC

-DNFA = -CX + DX + CC (from slide 15)

FCF = NOPAT – DNWC - DNFA

39Capital 2016

Free Cash Flow: Summary

40

FCF = NOPAT – DIC = NOPAT – DNFA – DNWC

NOPAT = EBIT·(1 – t) +DT

DNFA = CX – DX - CC

DNWC = DAR + DINV – DAP – DITP

If DT = 0 and CC = 0 (no change in deferred taxes and sell only fully depreciated assets)

FCF = EBIT·(1 – t) + DX – CX – DNWC

If DX = CX and DNWC = 0 (steady state)

FCF = EBIT·(1 – t)

Capital 2016

Investment Decisions Free cash flow is cash flow in excess of that required to

fund all projects that have positive net present values when discounted at the relevant cost of capital. Conflicts of interest between shareholders and managers over payout policies are especially severe when the organization generates substantial free cash flow. The problem is how to motivate managers to disgorge the cash rather than investing it at below the cost of capital or wasting it on organizational inefficiencies.

Jensen, Michael C., "Agency Cost Of Free Cash Flow, Corporate Finance, and Takeovers" .

American Economic Review, Vol. 76, No. 2, May 1986.41

42

R3,

190

$

R

3,19

0$

R3,

190

$

D

AR(8

7)$

ID

I19

$

IDI

19$

RC

3,10

3$

COGS

(2,2

90)

$

COGS

(2,2

90)

$

CFI

(298

.00)

$ ID

I19

$

OX

(449

)$

OX

(449

)$

COGS

(2,2

90)

$

DG20

$

DG20

$

CFO

228.

00$

O

X(4

49)

$

DX

(120

)$

DX(1

20)

$

CF

O*

259.

68$

D

INV

(47)

$

EBIT

370

$

EBIT

37

0.00

$

31.6

8$

D

AP56

$

IX

(67)

$

IT(1

03)

$

CO

GSC

+ O

X(2

,730

)$

IT

(103

)$

IX∙t

(22.

78)

$

CF

I(4

30.0

0)$

IX(6

7)$

N

P20

0$

tEB

IT∙

(125

.78)

$

CFI*

(520

.32)

$ IT

(1

03)

$

DX

120

$

ID

I(1

9)$

(9

0.32

)$

D

T5

$

DG

(20)

$

ID

I∙t6.

46$

DIT

P1

$

D

T5

$

D

T5

$

D

CE96

.00

$

ITC

(97)

$

DAR

(87)

$

NO

PAT

236.

68$

CFO

228

$

DIN

V(4

7)$

FC

F(2

60.6

4)$

DAP

56$

DIT

P1

$

DNW

C(7

7)$

CF

O22

8$

IDI

(19)

$

IDI

(19)

$

IDI∙t

6.46

$

IDI∙t

6.46

$

IDI∙ (

1-t )

(12.

54)

$

ID

I∙ (1-t )

(12.

54)

$

IX67

$

IX67

$

CX(5

00)

$

IX

∙t(2

2.78

)$

IX∙t

(22.

78)

$

D

X12

0$

IX∙ (1

-t)

44.2

2$

IX∙ (1

-t)

44.2

2$

CS

20$

DG(2

0)$

CF

O*

259.

68$

CF

O*

259.

68$

CC

-$

D

AR(8

7)$

CX

(500

)$

CX(5

00)

$

D

INV

(47)

$

DIS

50$

DIS

50$

DAP

56$

CS20

$

CS20

$

DIT

P1

$

-DIS

(50)

$

-DIS

(50)

$

DO

CE

(40.

32)

$

D

OC

E(4

0.32

)$

DO

CE

(40.

32)

$

D

OW

C(1

17.3

2)$

CFI*

(520

.32)

$

CFI*

(520

.32)

$

DIC

(497

.32)

$

FCF

(260

.64)

$ FC

F(2

60.6

4)$

FCF

(260

.64)

$

Dire

ct C

ash

Flow

Indi

rect

Cas

h Fl

owIn

com

e St

atem

ent

Cash

Flo

w F

rom

Fi

nanc

ing

43

Book and Fair Value

Capital 2016

44

Book Value of invested capital,

IC, (operating assets)

NWC +

NFA

Market or Fair Value, V, of

invested capital, IC

$

From balance sheet

From present value of future

cash flows discounted at cost of capital

Market or Fair Value of debt, D, and equity,

E

Capital 2016

45

Economic Profit

EP = ( roic – k ) ∙ IC

k is the cost of capital roic is the rate of return on invested capitalIC is the book value of the invested capital

Return on invested capital = roic ∙ IC = NOPATCost of capital = k ∙ IC

EP = NOPAT – k ∙ ICCapital 2016

46

Market Value Added

C = DB + EB

V = IC + MVA

V is the market value of the companyMVA is the market value added

Recall our previous DCF method of firm value

Capital 2016

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Harvard VC Case

Capital 2016

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Harvard VC Case

Capital 2016

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Harvard VC Case

Capital 2016

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