Financial Accounts Module 7

COMMON STOCK

Common stock reflects the amount of funding raised by issuing shares of stock to individuals that will hold a stake in the company. We would generally expect common stock to stay the same from year to year, unless the business is planning on issuing more stock or buying back its own outstanding shares. In our example below, we'll assume it is going to stay constant from one year to the next.

Which of the following represents the Net Working Capital for the business?

Current assets (excluding cash) less current liabilities equals Net Working Capital.

EBIAT

EBIAT re-applies the tax rate to a pre-tax amount that excludes the cost of interest.

most common methods to calculate free cash flows using the following equation:

FCF = (1-T)XEBIT+DEP-CAPX-<>NWC FCF - FREE CASH FLOWS, t- Tax Rate, EBIT - Earnings Before Interest and Taxes Dep- Depreciation and Amortization, CAPX - CAPITAL EXPENDITURES, <>NWC - CHANGE IN NETWORKING CAPITAL=

Forecasting and Valuation

Forecasting financials is an important part of accounting skills and is used by managers, financial analysts, and investors to predict future potential revenue streams, expenses, and cash flow. While creating financial reports for future periods involves a great deal of uncertainty, it is still very useful for businesses to make their best predictions based on the information they have. Forecasts can be used at a project level, for example, to help make a decision as to whether to undertake a particular project, or at a company level, for example, to decide whether to invest in a certain company or whether financing is needed.

What is the project's payback period?

In this example, the sum of net cash flows of the first 5 years is $144,000. Payback Period = 5 + ($155,000 - $144,000) / $22,000 = 5.5 years.

Metafacturing Inc. rented a new piece of equipment on January 1st and agreed to pay an annual rental fee of $24,000 at the end of each of the next 10 years. The weighted average cost of capital of the company is 8%. The present value of $1 for 10 years at 8% is 0.46319 The present value of an ordinary annuity of $1 for 10 years at 8% is 6.71008 What is the Present Value of the rental payments over 10 years?

It is calculated by multiplying the annual payment by the present value of an annuity factor. $24,000 * 6.71008 = $161,042

Suppose you are promised $1,000 a year from now, and another $1,000 in two years. If your discount rate is 5 percent, how much would you be willing to pay now for this investment opportunity?

Notice that the PV formula makes the answer negative. This is because it represents the amount you would be willing to pay today to receive the given cash flows. You would be willing to pay this amount because it is equivalent to the amount you will receive, so the net amount you pay and receive will be zero. So, if your discount rate is 5 percent, you would be willing to pay $1,859 now for the promise of $1,000 a year from now, and another $1,000 in two years. Another way to think of it is as the point of indifference. You would be indifferent between receiving $1,859 today, or receiving the promised cash flows of $1,000 a year from now and another $1,000 in two years.

The Gordon Growth Model

Present Value of Infinite Cash Flows=Cash flows in the final year of our projection/Discount rate-Growth Rate

Capital Expenditures (CAPX)

Remember that this refers to when cash is actually paid for property and equipment regardless of when the depreciation is recognized on the asset. If the business sells an asset during the period, the cash inflow will also be included in the calculation.

RETAINED EARNINGS

Retained earnings reflects the earnings that have been retained in the business to finance growth or future operations. For any given year, we can forecast retained earnings by adding the amount of prior year retained earnings plus current year net income, excluding amounts to be distributed to shareholders.

The IRR is the discount rate that sets the NPV of a project equal to zero.

The IRR allows us to see the percentage rate that would be earned for a given set of cash flows. This method incorporates the time value of money as the NPV does. This metric is often used when there is a lack of clarity or a lack of consensus within the company as to what discount rate should be used in an NPV calculation.

A project has a negative NPV. Which of the following statements is true regarding this project?

The IRR of the project is less than the WACC. IRR is the discount rate at which the net present value of an investment equals zero. Therefore: When NPV < 0, IRR < WACC. When NPV = 0, IRR = WACC. When NPV > 0, IRR > WACC.

The payback period tells us how fast the investors can expect to have their money returned.

This metric is more useful for someone who is concerned about limiting the downside potential rather than evaluating the whole project. It ignores the time value of money and the cash flows that occur after the payback period.

Second step in calculating free cash flows is EBIAT

To calculate EBIAT we multiply EBIT by 1 minus the tax rate. So at this stage, we have merely taken away the impact of interest from the income statement. We have re-applied the tax rate to the EBIT in arriving at EBIAT. EBIAT = (1-t) x EBIT

Suppose a company has a piece of machinery and the company spends money on maintenance to extend the useful life of the machine. The company is considering the decision of whether to capitalize the cost of maintenance to increase the asset's book value, or to record the cost of maintenance immediately as an expense. Does this decision affect free cash flow?

Yes, because EBIT will be affected by depreciation expense, which will be different depending on the decision. Even though depreciation is added back in the free cash flow calculation, there is a tax effect that will be picked up by the difference in depreciation that is included in EBIT.

a decrease in current liabilities represents

a use of cash which also decreases available funds.

Once EBIAT has been calculated, we have to

add depreciation back in the calculation of free cash flows. we will assume that the depreciation method is the same for both tax and financial reporting purposes. If the business has any amortization from intangible assets, we must add it back, as well, at this point.

Remember that increases in current assets represent

an investment of cash which decreases available funds

Variable costs

are costs that rise and fall with revenue or activity. An example could be the cost of flour at a bakery which would tend to change in proportion with sales. It stands to reason that many current asset accounts, such as accounts receivable and inventory, and current liability accounts, such as accounts payable, would tend to increase or decrease proportionately with revenue.

Calculating IRR:

=IRR(values) Values is an array of numbers for which to calculate the internal rate of return. Values must contain at least one positive value and one negative value. The order of values must be in the order of cash flows.

CALCULATE NPV

=NPV(E4,B3:B9)+B2

Calculating Present Value

=PV(rate,nper,pmt) Rate is the interest rate (also known as discount rate) for the period. Nper is the number of payment periods for the given cash flow. Pmt is the payment, or cash flow, to be discounted. Note that the PV formula assumes that the payments are equal over the total number of periods, meaning it is essentially a formula used to calculate the present value of an annuity.

Payback period

for the company to recover the amount of their initial investment.

Calculate Payback period

is to calculate the cumulative cash flows. Another way is that it is the break-even point or the point at which positive cash flows and negative cash flows incurred to date net to zero. By calculating, the cumulative cash flows, it is easy to see when the cash flows flip from being negative to being positive. If it doesn't flip exactly at a certain year, then you just need to find the portion of the following year that it takes to recover the remaining cash outlay.

Pro-forma financial statements

it involves determining future expected sales and finding trends among various accounts in the financial statements

Most economies experience inflation

meaning that the purchasing power of its currency is diminishing over time.

Net working capital - we measure

net working capital as current assets less current liabilities. To calculate the change in net working capital, which we need for our calculation of free cash flows, we take the difference between net working capital for the year being projected and the net working capital from the previous year.

In some cases, free cash flows are defined as

operating cash flow minus capital expenditures.

Net working capital

refers to the business having cash tied up in operations. As the business grows, it will typically need more cash to fund day to day operations. For example, as a business increases its sales, and services more customers, it will often need to increase the amount of inventory that it carries. This is cash that will be dedicated to the business and won't be available for other purposes.

free cash flows are intended to show

the company's normal ability to generate cash

IRR allows us to see the percentage rate that would be earned a given set of cash flows

this method incorporates a time value of money as the NPV does. The higher NPV and IRR, the more preferable choice

If the business has already paid for something that will be used at no additional cost by the new project,

those costs are omitted because they are sunk costs and shouldn't factor into the decision of whether or not the project should be undertaken.

The first step in calculating free cash flows is to calculate Earnings Before Interest and Taxes or EBIT

to eliminate the impact of how the business or investment is financed. The information for calculating EBIT comes from the income statement- net income, we add back the interest expense and income taxes expense lines. The result is EBIT.

With all cash flows determined, the value of the project can be calculated by

using the net present value, or NPV, of the cash flows. The NPV nets out the present values of all the cash inflows and outflows of the project. The result is a single number that gives a good indication of what a business or a particular investment is worth today. It is important that the NPV uses only relevant cash flows in the analysis.

depreciation is a non-cash expense

we need to add back depreciation to calculate free cash flows.