Chapter 02 Financial Statements

2 Value = FCF 1 FCF 2 FCF ∞ (1 + WACC) 1 (1 + WACC) ∞ (1 + WACC) 2 Free cash flow (FCF) Market interest rates Firm’s business riskMarket risk aversion Firm’s debt/equity mix Cost of debt Cost of equity Weighted average cost of capital (WACC) Sales revenues Operating costs and taxes Required investments in operating capital − − = Determinants of Intrinsic Value: Calculating FCF...

Financial Statements

Balance Sheet Financial Management - Reza Masri4

Balance Sheet Financial Management - Reza Masri5

Balance Sheet The basic principles to read Balance Sheet are: LIQUIDITY: Promptness with which assets are expected time to be converted into cash REPAYING PERIOD : Time within which obligations are expected to be satisfied Financial Management - Reza Masri6

Balance Sheet Financial Management - Reza Masri7

Balance Sheet Financial Management - Reza Masri8

Balance Sheet Financial Management - Reza Masri9

Balance Sheet Financial Management - Reza Masri10

Balance Sheet Financial Management - Reza Masri11 A snapshot of financial position on the last day of a period Snapshot changes as position changes: B/S may look different at different times of a period Asset: things that company owns, listed in “liquidity” order Liabilities & Equity: claims against company’s value, listed in the “maturity” order

Income Statement Financial Management - Reza Masri12

Income Statement Financial Management - Reza Masri13

Income Statement Financial Management - Reza Masri14

Financial Management - Reza Masri15 Income Statement A basic principle to read Income Statement: DEDUCTING PRINCIPLE To deduct progressively costs from revenues following the production- sales cycle Goals: To show different margins

Income Statement Financial Management - Reza Masri16

Income Statement Financial Management - Reza Masri17

Income Statement Financial Management - Reza Masri18

Income Statement Financial Management - Reza Masri19

Income Statement Financial Management - Reza Masri20

Income Statement Financial Management - Reza Masri21 Reflects financial performance during a period

Statement of Retained Earnings Financial Management - Reza Masri22

Statement of Cash Flows Financial Management - Reza Masri23

Statement of Cash Flows Financial Management - Reza Masri24 Net Cash Flow = Net Income – Noncash Revenues + Noncash Charges

25 What are the five uses of FCF? 1. Pay interest on debt. 2. Pay back principal on debt. 3. Pay dividends. 4. Buy back stock. 5. Buy nonoperating assets (e.g., marketable securities, investments in other companies, etc.)

Financial Management - Reza Masri26 Determining Free Cash Flow (FCF) Operating Cash Flow – Investment in Operating Capital NOPAT (Net Operating Profit After Taxes) Amount of profit a company would generate if it had no debt and held no financial assets Take out impacts of financing & investing decisions to have pure measure of operating performance NOPAT = EBIT(1-Tax Rate)

Financial Management - Reza Masri27 Free Cash Flows (FCF) Cash flows can not be maintained over time unless depreciated fixed assets are replaced, so management is not completely free to use net cash flows. Free Cash Flows is the cash flow actually available for distribution to investors after the company has made all the investments in fixed assets and working capital necessary to sustain ongoing operation FCF = NOPAT – Net investment in operating capital Gross Investment = Net Investment + Depreciation FCF = (NOPAT + Depreciation) – Gross Investment in operating capital NOPAT = EBIT(1-Tax Rate)

Financial Management - Reza Masri28 Operating Capital Total net operating capital = Net operating working capital + Operating long term assets Net operating working capital = Operating current asset – Operating current liabilities Net operating working capital = (Cash + Accounts Receivable + Inventories) - (Accounts Payable + Accruals)

Financial Management - Reza Masri29 Free Cash Flows (FCF) - MicroDrive Illustration

Financial Management - Reza Masri30 Return on Invested Capital MicroDrive Illustration

Financial Management - Reza Masri31 Market Value Added (MVA) MVA = Market Value of Stock – Equity capital supplied = (shares o/s)(stock price) – Total Common Equity To incorporate stock prices in the analysis as the primary goal of management is to maximize the firm’s value, hence the outstanding shares times stock price Measures the effects of managerial actions since the inception of the company

Financial Management - Reza Masri32 Economic Value Added (EVA) EVA = (Operating capital)(ROIC – WACC) EVA = Net Operating Profit After Taxes (NOPAT) - After-tax dollar cost of capital used to support operations = EBIT(1-Tax Rate) – (operating capital)(WACC) Focuses on managerial effectiveness in a given year

Financial Management - Reza Masri33 MVA & EVA - Illustration