Chapter 2
A company has NOPAT of $30 million, and its depreciation and amortization expense is $10 million. During the year the company's gross capital expenditures (total purchases of fixed assets) were $20 million and its net operating working capital increased by $10 million. A. What is the company's operating cash flow? B. What is its free cash flow?
A. 40 million B. 0
A. What is free cash flow? B. .Why is free cash flow the most important determinant of a firm's value?
A. The cash flow actually available for distribution to all investors (stockholders and debt-holders) after the company has made all the investments in fixed assets, new products, and working capital necessary to sustain ongoing operations. B. To be more specific, the value of a company's operations depends on its expected future free cash flows (FCF), defined as after-tax operating profit minus the investments in working capital and fixed assets necessary to sustain the business.
If a company has high cash flows, does this mean that its cash and equivalents will also be high? Explain.
Its net cash flow represents the cash a business generates in a given year. However, the fact that a company generates a high cash flow does not necessarily mean that the cash reported on its balance sheet is also high. •Cash flow is not normally used just to build up the cash account. Rather, it is used in a variety of ways
What is net operating working capital?
NOWC: Operating working capital less accounts payable and accruals. It is the working capital acquired with investor-supplied funds. •NOWC = All current assets required in operations - All non-interest-bearing current liabilities
What is total operating capital?
Total operating capital = Net operating working capital + Net fixed assets
accounting profit
a firm's net income as reported on its income statement
amortization
a non-cash charge similar to depreciation except that it is used to write off the costs of intangible assets
statement of cash flows
a statement reporting the impact of a firm's operating, investing, and financing activities on cash flows over an accounting period
What is the statement of cash flows, and what are some questions it is designed to answer?
statement of cash flows is a financial statement that measures activities involving cash receipts and cash payments over an interval of time.
net cash flow
the actual net cash, as opposed to accounting profit (net income) that a firm generates during a specified period
depreciation
the charge to reflect the costs of assets used up in the production process. Depreciation is not a cash outlay.
capital components
various types of debt, preferred stock, common equity
Total Assets
current assets, long-term assets
total liabilities and equity
current liabilities, long-term debt, stockholders' equity
r(d)
= interest rate on the firms new debt
operating cash flow formula
=EBIT(1-tax rate) + depreciation and amortization
total operating capital formula
=NOWC+net fixed assets
r(d)(1-T)
=after-tax component cost of debt where T is the firm's marginal tax rate -the debt cost used to calculate the weighted average cost of capital. The after tax cost of deb is lower than the before tax cost because interest is deductible for tax purposes
NOWC formula
=all current assets required in operations-all non interest bearing current liabilities
EBIT formula
=sales revenues-operating costs
How do we estimate net cash flow, and how does it differ from accounting profit?
A business's net cash flow differs from its accounting profit because some of the revenues and expenses listed on the income statement are not paid in cash during the year. •Net cash flow = Net income + Depreciation and amortization
How can you tell if a company is profitable?
Income statement; if revenues exceed expenses a company has meet income and is profitable
Financing activities
Borrowing, stockholders' investment, distributions to stockholders
if you discount at WACC
Cash flows have to be projected just as you would for a capital investment project. •Do not deduct interest. •Calculate taxes as if the company were all-equity financed. •The value of interest tax shields is picked up in the WACC formula. Discounting at WACC values the assets and operations of the company. •If the object is to value the company's equity, that is, its common stock, don't forget to subtract the value of the company's outstanding debt.
What is NOPAT?
EBIT(1 - Tax rate) is often referred to as NOPAT, or net operating profit after taxes, and it is the profit a company would generate if it had no debt and held only operating assets. Thus, •Operating cash flow = NOPAT + Depreciation and amortization
Net operating profit after taxes (NOPAT) formula
EBIT(1-tax rate)
Identify and briefly explain the three types of activities shown in the statement of cash flows.
Operating cash flows include cash receipts and cash payments for transactions involving revenues and expenses. •Investing cash flows generally include cash transactions for the purchase and sale of investments and productive long-term assets. •Long-term assets are resources owned by a company that are thought to provide benefits for more than one year. •Financing cash flows include cash transactions with lenders, such as borrowing money and repaying debt,
How does net cash flow differ from accounting profit.
Some of the revenues and expenses listed on the income statement are not paid in cash during the year
capital asset pricing model (CAPM)
Step 1: Estimate the risk-free rate. Many analysts use the 10-year Treasury bond rate as a measure of the risk-free rate. Others use a short-term Treasury bill rate. •Step 2: Estimate the stock's beta coefficient, and use it as an index of the stock's risk. •Step 3: Estimate the expected market risk premium. Recall that the market risk premium is the difference between the return that investors require to hold an average stock and the risk-free rate. •Step 4: Substitute the preceding values into the CAPM equation to estimate the required rate of return on the stock in question
r(d) formula
before tax component cost of debt
current assets
cash and equivalents accounts receivable inventory
operating cash flows
cash receipts and cash payments for transactions involving revenues and expenses
financing cash flows
cash transactions with lenders, such as borrowing money and replying debt, and with stockholders, such as issuing stock and paying dividends
component cost
cost of each component
EBIT
earnings before interest and taxes, and it is often referred to as operating income
EBITDA
earnings before interest, taxes, depreciation and amortization
investing cash flows
generally include cash transactions for the purchase and sale of investments and productive long-term assets
after tax cost of debt
interest rate-tax savings
Net cash flow formula
net income+depreciation and amortization
long-term (fixed) assets
net plant and equipment other long-term assets
Net operating working capital (NOWC)
operating working capital less accounts payable and accruals. It is the working capital acquired with investor-supplied funds
Cash flow used to
pay dividends increase inventories financing accounts receivable investing in fixed assets retiring debt buying back common stock
cost of retained earnings
rate of return required by stockholders on a firms common stock, cost of common equity
investing activities
resources owned by the company
operating activities
sales to customers, costs of selling to customers