International Financial Markets

Determining cash flows for company valuation and CF profile

Earnings and CFs

Reorganization of financial reports: balance sheet.

Reorganization of financial reports: balance sheet. In order to properly construct CFs, it can be useful to reorganize the BS as follows.

In order to properly construct cash flows, it can be useful to reorganize the BS as follows:

• Reorganizing the balance sheet according to the functional principle consists in the aggregation of assets and liabilities based on the business operations they belong to.

Functional principle. Reorganizing the balance sheet according to the functional principle consists in the aggregation of assets and liabilities based on the business operations they belong to.

Points out several aggregations of the value used in different approaches followed by several valuation techniques.

Reorganization of financial reports: balance sheet. Points out several aggregations of the value used in different approaches followed by several valuation techniques.

Introduces distinction between core operating assets and noncore or complementary businesses.

Introduces distinction between core operating assets and noncore or complementary businesses.

Facoltà di Scienze Bancarie, Finanziarie e Assicurative 4.

The functional reorganization is particularly useful in financial valuation because the connection between the BS and IS allows us to establish a relationship between specific flows of results and the specific assets used.

Facoltà di Scienze Bancarie, Finanziarie e Assicurative 5.

This enables:

• Rigorous analysis of profitability.
• Simplifies the construction of economic and financial plans.

Also, we are able to distinguish specific categories of revenues and costs of non-core activities enabling us to prepare data for the separate valuation of company’s core activity and complementary surplus assets.

Sum of parts (SOP). When company needs to be evaluated using a sum of parts approach, we need to reconstruct costs relative to each separate business area, usually up to the EBIT level.

Reorganization of financial reports: income statement

Reclassification of income statement

Income statement at added value.

1. Production value achieved during fiscal year.

• Consumption of raw materials and components acquired from third parties.
• Costs of services acquired from outside.
• Other external expenses, for example administration and control, organization, finance.

2. Added Value.

• Labor costs.

3. EBITDA.

• Depreciation and amortizations and provisions.

4. Operating Income (EBIT).

Financial expenses (+ financial revenues) / + Net results from non-core activities.

5. Gross Operating Income from Continuing Operations.

Extraordinary losses (+ extraordinary gains).

6. EBT Tax expenses.

7. Net Income.

Facoltà di Scienze Bancarie, Finanziarie e Assicurative 7.

Cash flow definitions

FCFO. 1) Cash flow generated by the operating business.

FCFE. 2) The net flows available to shareholders.

Noncore businesses should be valued autonomously.

FCFE calculation: equity side valuation

To estimate how much cash a firm can afford to return to its stockholders, we begin with the net income—the accounting measure of the stockholders’ earnings during the period—and convert it to a cash flow by subtracting out a firm’s reinvestment needs.

First, any capital expenditures, defined broadly to include acquisitions, are subtracted from the net income, since they represent cash outflows. Depreciation and amortization, on the other hand, are added back in because they are accounting but not cash expenses. The difference between capital expenditures and depreciation (net capital expenditures) is usually a function of the growth characteristics of the firm. High-growth firms tend to have high net capital expenditures relative to earnings, whereas low-growth firms may have low, and sometimes even negative, net capital expenditures.

Second, increases in working capital drain a firm’s cash flows, while decreases in working capital increase the cash flows available to equity investors. Firms that are growing fast, in industries with high working capital requirements, retailing for instance, typically have large increases in working capital. Since we are interested in the cash flow effects, we consider only changes in noncash working capital in this analysis.

Finally, equity investors also have to consider the effect of changes in the levels of debt on their cash flows. Repaying the principal on existing debt represents a cash outflow, but the debt repayment may be fully or partially financed by the issue of new debt, which is a cash inflow.

Cash Flow Definitions.

Again, netting the repayment of old debt against the new debt issues provides a measure of the FCFE calculation – Equity Side Valuation cash flow effects of changes in debt.

• + Net Income – Adjusted.
• +/- Non Cash Expenditure (other than D&A) / Non Cash Revenues.
• - Net Capex = (Capital Expenditures – Depreciation/Amortization).
• - Changes in non-cash Working Capital.
• - (Principal Debt Repayments - New Debt Issues).
• = Free Cash Flows to Equity.

Facoltà di Scienze Bancarie, Finanziarie e Assicurative 9.

Cash flow definitions: FCFO and FCFF

FCFO (FCFF) calculation: asset side valuation

FCFO calculation - Asset Side Valuation.

• + FCFE.
• + Interest Expense (1 – Tax Rate).
• + (Principal Debt Repayments - New Debt Issues).
• = Free Cash Flows from Operations (FCFO).

Or:

• + Operating Income (EBIT) – Adjusted.
• +/- Non Cash Expenditure (other than D&A) / Non Cash Revenues.
• - Taxes on EBIT.
• - Reinvestment Needs (Net Capital Expenditures and Working Capital).
• = Free Cash Flows from Operations (FCFO).

(If preferred dividends exist, it also needs to be netted out).

(If preferred dividends also exist, it also needs to be netted out).

Facoltà di Scienze Bancarie, Finanziarie e Assicurative 10.

Previous formulas highlight

FCFO:

• Free cash flow to operations or free cash flow to firm FCFF.
• Term taxes measures the theoretical fiscal outflow calculated on the operating result in a scenario of no debt; in this case EBIT equals EBT.

FCFE:

• Its value depends not only on the incidence of interest and income taxes but also on the change in the net financial position.
• CF to shareholders depends on the future operation choices involving the use of debt.

FCFF = FCFO.

The free cash flow to the firm (FCFF) is the sum of the cash flows to all claim holders in the firm, including common stockholders, bondholders, and preferred stockholders. There are two ways of measuring the free cash flow to the firm.

One is to add up the cash flows to the claim holders, which would include cash flows to equity, defined either as free cash flow to equity or as dividends; cash flows to lenders, which would include principal payments, interest expenses, and new debt issues; and cash flows to preferred stockholders, usually preferred dividends: …

Note, however, that we are reversing the process that we used to get to free cash flow to equity, where we subtracted out payments to lenders and preferred stockholders to estimate the cash flow left for stockholders.

A simpler way of getting to free cash flow to the firm is to estimate the cash flows prior to any of these claims. Thus we could begin with the earnings before interest and taxes, net out taxes and reinvestment needs, and arrive at an estimate of the free cash flow to the firm:

FCFF = EBIT(1 - Tax rate) + Depreciation - Capital expenditure - Δ Working capital.

Since this cash flow is prior to debt payments, it is often referred to as an unlevered cash flow. Note that this free cash flow to the firm does not incorporate any of the tax benefits due to interest payments. This is by design, because the use of the after-tax cost of debt in the cost of capital already considers this benefit, and including it in the cash flows would double count it.

Some basic assumptions

The structure and consistency of project assumptions determine the quality of the project and the whole valuation process. Three main categories:

• Assumptions on the general and economic environment. GDP growth rate, evolution of consumption, exchange rates, interest rates, expected inflation rates.
• Assumptions regarding the company’s industry or the project that is being valued. Growth rate of the market, competitors’ strategies, evolution of fares, normative actions that affect the industry.
• More specific assumption about the company or the project that is being valued.

From reported to actual earnings: adjusting accounting

Make sure that there are no financial expenses mixed in with operating expenses.

Financial expense: any commitment that is tax deductible that you have to meet no matter what your operating results. Failure to meet it leads to loss of control of the business.

• Operating Leases: Example, while accounting convention may treat operating leases as operating expenses, they are really financial expenses and need to be reclassified as such. This has no effect on equity earnings but does change the operating earnings.

Make sure that there are no capital expenses mixed in with the operating expenses.

Capital expense: any expense that is expected to generate benefits over multiple periods.

• R & D Adjustment: Example, since R&D is a capital expenditure rather than an operating expense, the operating income has to be adjusted to reflect its treatment.

Operating leases

The most prominent of these off-balance sheet items are operating leases. Chapter 3 contrasted operating and capital leases and noted that operating leases are treated as operating expenses rather than financing expenses.

Consider, though, what an operating lease involves. A retail firm leases a store space for 12 years and enters into a lease agreement with the owner of the space agreeing to pay a fixed amount each year for that period. We do not see much difference between this commitment and borrowing money from a bank and agreeing to pay off the bank loan over 12 years in equal annual installments.

There are therefore two adjustments we will make when we estimate how much debt a firm has outstanding.

• We will consider only interest-bearing debt rather than all liabilities. We would include both short-term and long-term borrowings in debt.
• We will also capitalize operating leases and treat them as debt.

Capitalizing OLs. Converting operating lease expenses into a debt equivalent is straightforward. The operating lease commitments in future years, which are revealed in the footnotes to the financial statements for U.S. firms, should be discounted back at a rate that reflects their status as unsecured and fairly risky debt. As an approximation, using the firm’s current pretax cost of borrowing as the discount rate yields a good estimate of the value of operating leases.

There is one final issue relating to capitalization. Earlier in this chapter it was stated that the interest coverage ratio could be used to estimate a synthetic rating for a firm that is not rated. For firms with little in terms of conventional debt and substantial operating leases, the interest coverage ratio used to estimate a synthetic rating has to be adapted to include operating lease expenses.

Converting OLs to debt. In Chapter 8, the basic approach for converting operating leases into debt was presented. You discount future operating lease commitments back at the firm’s pretax cost of debt. The present value of the operating lease commitments is then added to the conventional debt of the firm to arrive at the total debt outstanding.

Adjusted debt = Debt + Present value of lease commitments.

Once operating leases are recategorized as debt, the operating incomes can be adjusted in two steps. First, the operating lease expense is added back to the operating income, since it is a financial expense. Next, the depreciation on the leased asset is subtracted out to arrive at adjusted operating income:

Adjusted operating income = Operating income + Operating lease expenses – Depreciation on leased asset.

If you assume that the depreciation on the leased asset approximates the principal portion of the debt being repaid, the adjusted operating income can be computed by adding back the imputed interest expense on the debt value of the operating lease expense:

Adjusted operating income = Operating income + Debt value of operating lease expense × Interest rate on debt.

From reported to actual earnings: operating leases example

The Gap in 200X has conventional debt of about $1.97 billion on its balance sheet and its pre-tax cost of debt is about 6%.

Its operating lease payments in the 200X were $978 million and its commitments for the future are shown below.

From Reported to Actual Earnings: Operating Leases (example).

• Adjusted Debt outstanding = $1,970m + $4,397m = $6,367m.
• Adjusted EBIT = Reported EBIT + OL Exp. this year – Depreciations.
• = $1,012 + 978 – (4,397/7) = $1,362m (7 year useful life for assets).
• Approximate EBIT = $1,012 + $4,397 · 6% = $1,276m.

Facoltà di Scienze Bancarie, Finanziarie e Assicurative 18.

Operating lease expenses may be treated as operating expenses in computing operating income. In reality, operating lease expenses should be treated as financing expenses, with the following adjustments to earnings and capital.

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Debt Value of Operating Leases = Present value of operating lease commitments at the pre-tax cost of debt.

When you convert operating leases into debt, you also create an asset to counter it of exactly the same value. 233.

Adjusting earnings

Capitalizing R&D expenses

Research expenses, notwithstanding the uncertainty about future benefits, should be capitalized.

To capitalize and value research assets, we make an assumption about how long it takes for research and development to be converted, on average, into commercial products. This is called the amortizable life of these assets. This life will vary across firms and reflect the time involved in converting research into products.

To illustrate, research and development expenses at a pharmaceutical company should have fairly long amortizable lives, since the approval process for new drugs is long. In contrast, research and development expenses at a software firm, where products tend to emerge from research much more quickly, should be amortized over a shorter period.

Once the amortizable life of research and development expenses has been estimated, the next step is to collect data on R&D expenses over past years ranging back over the amortizable life of the research asset. Thus, if the research asset has an amortizable life of five years, the R&D expenses in each of the five years prior to the current one have to be obtained.

For simplicity, it can be assumed that the amortization is uniform over time, which leads to the following estimate of the residual value of the research asset today:

Value of the research asset = Σ R&D_t × (n + t) / n, from t = -n to t = 0.

Thus, in the case of the research asset with a five-year life, you cumulate one-fifth of the R&D expenses from four years ago, two-fifths of the R&D expenses from three years ago, three-fifths of the R&D expenses from two years ago, four-fifths of the R&D expenses from last year, and this year’s entire R&D expense to arrive at the value of the research asset. This augments the value of the assets of the firm and, by extension, the book value of equity.

Adjusted book value of equity = Book value of equity + Value of the research asset.

Finally, the operating income is adjusted to reflect the capitalization of R&D expenses. First, the R&D expenses that were subtracted out to arrive at the operating income are added back to the operating income, reflecting their recategorization.

To capitalize and value research assets, we make an assumption about how long it takes for research and development to be converted, on average, into commercial products. This is called the amortizable life of these assets. This life will vary across firms and reflect the time involved in converting research into products. To illustrate, research and development expenses at a pharmaceutical company should have fairly long amortizable lives, since the approval process for new drugs is long. In contrast, research and development expenses at a software firm, where products tend to emerge from research much more quickly, should be amortized over a shorter period.

Once the amortizable life of research and development expenses has been estimated, the next step is to collect data on R&D expenses over past years ranging back over the amortizable life of the research asset. Thus, if the research asset has an amortizable life of five years, the R&D expenses in each of the five years prior to the current one have to be obtained. For simplicity, it can be assumed that the amortization is uniform over time, which leads to the following estimate of the residual value of the research asset today:

Value of the research asset = Σ R&D_t × (n + t) / n, from t = -n to t = 0.

Thus, in the case of the research asset with a five-year life, you cumulate one-fifth of the R&D expenses from four years ago, two-fifths of the R&D expenses from three years ago, three-fifths of the R&D expenses from two years ago, four-fifths of the R&D expenses from last year, and this year’s entire R&D expense to arrive at the value of the research asset. This augments the value of the assets of the firm and, by extension, the book value of equity.

Adjusted book value of equity = Book value of equity + Value of the research asset.

Finally, the operating income is adjusted to reflect the capitalization of R&D expenses. First, the R&D expenses that were subtracted out to arrive at the operating income are added back to the operating income, reflecting their recategorization.