1. Copyright © 2012 Pearson Prentice Hall. All rights reserved. Chapter 4 Cash Flow and Financial Planning

2. © 2012 Pearson Prentice Hall. All rights reserved. 4-2 Analyzing the Firm’s Cash Flow Cash flow (as opposed to accounting “ profits ” ) is the primary ingredient in any financial valuation model. From an accounting perspective, cash flow is summarized in a firm ’ s statement of cash flows. From a financial perspective, firms often focus on both operating cash flow, which is used in managerial decision-making, and free cash flow, which is closely monitored by participants in the capital market.

3. © 2012 Pearson Prentice Hall. All rights reserved. 4-3 Developing the Statement of Cash Flows The statement of cash flows summarizes the firm ’ s cash flow over a given period of time. Firm ’ s cash flows fall into three categories: –Operating flows: cash flows directly related to sale and production of the firm ’ s products and services. –Investment flows: cash flows associated with purchase and sale of both fixed assets and equity investments in other firms. –Financing flows: cash flows that result from debt and equity financing transactions; include incurrence and repayment of debt, cash inflow from the sale of stock, and cash outflows to repurchase stock or pay cash dividends.

4. © 2012 Pearson Prentice Hall. All rights reserved. 4-4 Table 4.3 Inflows and Outflows of Cash

5. © 2012 Pearson Prentice Hall. All rights reserved. 4-5 Table 4.4 Baker Corporation 2012 Income Statement ($000)

6. Income at different stages Operating Income: Income from firm’s regular core business. It is also called Earnings Before Interest and Tax (EBIT). – Companies can have same EBIT but different Net Income because of different Interest amount. The more debt a firm has the more interest they have to pay which changes the Net Income. – Retained Earnings represent a claim against assets. It does not represent cash and are not available for dividends or anything else, only for investing activities.

7. Income at different stages Depreciation: The charge to reflect the cost of assets used up in the production process. Depreciation is not a cash outflow. Amortization: A noncash charge similar to depreciation except that it is used to write off the costs of intangible assets. Since these are non-cash so Earnings Before Interest Tax Depreciation and Amortization (EBITDA) is also an important indicator of firm performance

8. © 2012 Pearson Prentice Hall. All rights reserved. 4-8 Table 4.5a Baker Corporation Balance Sheets ($000)

9. © 2012 Pearson Prentice Hall. All rights reserved. 4-9 Table 4.5b Baker Corporation Balance Sheets ($000)

10. © 2012 Pearson Prentice Hall. All rights reserved. 4-10 Table 4.6 Baker Corporation Statement of Cash Flows ($000) for the Year Ended December 31, 2012

11. © 2012 Pearson Prentice Hall. All rights reserved. 4-11 Interpreting Statement of Cash Flows The statement of cash flows ties the balance sheet at the beginning of the period with the balance sheet at the end of the period after considering the performance of the firm during the period through the income statement. The net increase (or decrease) in cash and marketable securities should be equivalent to the difference between the cash and marketable securities on the balance sheet at the beginning of the year and the end of the year.

12. © 2012 Pearson Prentice Hall. All rights reserved. 4-12 Operating Cash Flow A firm ’ s operating Cash Flow (OCF) is the cash flow a firm generates from normal operations — from the production and sale of its goods and services. OCF may be calculated as follows: NOPAT = EBIT  (1 – T) OCF = NOPAT + Depreciation OCF = [EBIT  (1 – T)] + Depreciation

13. © 2012 Pearson Prentice Hall. All rights reserved. 4-13 Operating Cash Flow (cont.) Substituting for Baker Corporation, we get: Thus, we can conclude that Baker ’ s operations are generating positive operating cash flows. OCF = [$370  (1 –.40)] + $100 = $322

14. Free Cash Flow (FCF) FCF is the amount of cash that could be withdrawn from a firm without harming it’s ability to operate and to produce future cash flow. FCF = EBIT(1-T) + Depreciation – (Capital expenditure + Increase in NetWorkingCapital) EBIT(1-T) = Net Operating Profit After Tax (NOPAT) Capital Expenditure = Change in Long-term assets Increase in NWC = Change in current assets – Change in payables and accruals

15. Net Working Capital Current Assets are often called working capital because they are used and replaced (“turned over”) throughout the year. Net working capital = Current assets – (Payables + Accruals) – Payables and Accruals are like “free” loans since they don’t bear any interest. – NWC is the amount of money company must obtain from non-free sources to fund its current assets.

16. Sources of Funds Debt or Liabilities: – Long-term debt – Interest bearing. Ex: bonds, loans. – Current debt – Non-interest bearing. Ex: payables, accruals. Preferred Stock - Part of equity that is a hybrid of debt and common stock. Common Stock – Portions of ownership of a company. In the event of bankruptcy priority of payback are as follows: debt-preferred stocks-common stocks

17. © 2012 Pearson Prentice Hall. All rights reserved. 4-17 Free Cash Flow Free cash flow (FCF) is the amount of cash flow available to investors (creditors and owners) after the firm has met all operating needs and paid for investments in net fixed assets (NFAI) and net current assets (NCAI). Where: FCF = OCF – NFAI – NCAI NFAI = Change in net fixed assets + Depreciation NCAI = Change in CA – Change in (A/P + Accruals)

18. © 2012 Pearson Prentice Hall. All rights reserved. 4-18 Free Cash Flow (cont.) Using Baker Corporation we get: Thus, the firm generated adequate cash flow to cover all of its operating costs and investments and had free cash flow available to pay investors. Negative FCF means Operating Income is not enough to cover for the new ventures and the working capital FCF = $322 – $300 – $0 = $22 NFAI = [($1,200 – $1,000) + $100] = $300 NCAI = [($2,000 – $1,900) + ($800 - $700)] = $0

19. Income Taxes Individuals are taxed on wages, salaries, and on investment income like dividends, interest, and capital gains. – Capital Gain or Loss is the profit/loss from the sale of a capital asset (stocks, bonds, and real estates) for more/less than it’s purchase price. – The tax rates are progressive meaning the higher one’s income the larger the percentage paid in taxes.

20. Income Taxes Corporations also have to pay taxes on their income at a progressive rate. – Interest and dividends received on bonds and stocks are taxed. But for dividends the rule is more relaxed and only 30% is taxed. – Interest paid are deducted from taxable income but dividends paid are not. – Corporate capital gains are also taxed.