Sebastian Perrier

+ EBIT [from Income Statement, do not deduct interest bc WACC already includes Kd]

- TAX [income tax charged by Governments]

+ Depeciation [not a cash movement]

-  Delta Working Capital

- Delta Capital Expenditure

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Free Cash Flow (FCF)

–> PV=FCF/(1-WACC)*n

–> NPV=PV- Initial Investment + PV of “Residual Values”

Residual Values:

There are various ways of calculating the residual values….

a) Profit After Tax for the last period by P/E Ratio [PATn x P/E]

b) FCF of the last year by growh rate, divided by annuity [FCF(1+g)/WACC-g)

In order to calculate the NET PRESENT VALUE of an investment project, we need to know what is the discount rate at which to discount the Cash Flows. This discount rate is called the weighted average cost of capital (WACC), which is the rate that a company is expected to pay on average to all its security holders to finance its assets.

HOW TO CALCULATE THE DISCOUNT RATE “r” or “WACC”?

First, calculate the COST OF EQUITY (Ke):

1. Unique Risk: investors expect a determine level of return for each project and its related risk. This unique risk is calculated using historical data; you can calculate the “standard deviation” of the returns that investors got by investing in XX shares.
2. Diversification: however, unique risk can be eliminated by diversification; i.e. you buy stocks of umbrellas and ice-creams.
3. Market Risk: but experience has shown that risk can be mitigated until a level where, no matter how more you diversify your portfolio, you’ll still have the same level of “market risk” which cannot be avoided (e.g. earthquake, macro economic cycles, government policies, etc). So, assuming investors are intelligent and they have a diversified portfolio, the only risk they have to care is market risk.
4. Beta: but how is market risk calculated? With Beta. Beta is a measure of the extent to which the return of the shares of a specific company “moves together” with the returns of market indexes which are 100% diversified portfolios (e.g. S&P, NASDAC, ISEC, etc). Beta > 1 means that the share is volatile, Beta < 1 means stable, and Beta=0 means that it moves identically as the market index.
5. Capital Asset Pricing Model (CAPM): If we use the two following benchmarks a) the return of risk-free shares with a Beta=0 (like US Gov Bonds) and b) the return of market index – 100% diversified portfolio – we can draw the “Security Market Line“. Graphing Return on the y axis and Beta on the x axis, the return of any share will fall into this Security Market Line. Therefore, following the equation of a line, to calculate a company’s expected return on equity (or its cost of equity): Ke= Rf + B [Rm-Rf]

In other words, expected return on a share will consist of a minimum (R_f) [risk free, like GovBonds at 3%], plus a premium for risk [Rm-Rf] “market index return minus risk free” , that is proportionate to beta value of that industry (the risk of that industry, or portfolio). The expected return on any investment, or portfolio, will consist of the risk-free rate of return, and a premium for risk, which is proportional to beta.

Second, if the project also has debt, also calculate the COST OF DEBT (Kd):

To calculate the cost of debt is easyier, its the interest that the bank charges for the issued debt. But note that debt financing has a “tax shield”, because taxes are calculated after subtracting interest cost to profit.

Therefore: WACC= Kd (1-tax rate) . %D + Ke . %E

Click here to download example.

Calculation for one period:

• FV=PV + PV. r -> FV=PV(1+r) -> PV=FV/(1+r)

Calculation for multiple periods:

• PV=[FCF1/(1+r) + FCF2/(1+r)'2 + ... + FCFn/(1+r)'n]

Calculation of NPV:

• NPV = PV – Initial Investment

Calculation of IRR:

• Solve “r” (the discount rate) that gives an NPV of zero

NOTES:

• FCF1, FCF2, FCFn – Projected Yearly Free Cash Flows
• r – Interest Rate or Cost of Capital (carefully use the project’s WACC, not the company’s one bc risks are different)
• I – Initial Investment
• n – Project Life (years, months, etc, but put r according to period specified)

Mathematical Problems with the IRR

(a) Negative Cash Flows and Multiple Rates of Return; e.i. when cash flows are +-+, gives multiple IRR, and thus mathematical calculation gives an error.

(b) The Re-investment Problem: bc when you borrow, WACC can change due to different risks.

(c) Ranking Differences: cannot decide in terms of size of projects and timing of cash.

Investment Appraisal and Inflation

(a) Adjust projected cash flows, to account for anticipated fall in value of money

(b) Re-state the discount rate, to allow for anticipated impact of expected inflation

APPENDIX – Future Values and Discount Rate Table

There are four steps in the investment decision:

1. Identify investment opportunities
2. Put numbers to each opportunity (this is the most difficult part!)
3. Evaluate and make a decision (NPV calculation)
4. Monitor investment and control

In point 3, how to make a decision, there are 3 possible analyses:

• PAYBACK PERIOD (ignores time value of money and ignores cash flows after payback period)
• INTERNAL RATE OF RETURN (good to compare, but doesn’t allow + – + flows bc of maths error)
• NET PRESENT VALUE (forces you to get WACC, considers time value of money and has not maths problems).

Decision criteria:

• Choose project that maximizes NPV
• Choose project in which IRR is higher than WACC

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CFO’s objective: MAXIMIZE SHAREHOLDERS VALUE (while complying with law and ethic values):

a. Do not run out of cash! Cash-flow management.

b. Make good investment decisions!

c. Make good financing decisions!

In order to make a banker let you money, you must consider all the elements in the acronym PRACTICE:

1. Purpose
2. Repayment
3. Amount
4. Caracter / Capital / Competence
5. Term
6. Interest
7. Security
8. Experience

Write me if you want more information about each line.

In choosing between Debt or Equity financing, a good way to analyze the decision is to use the FRICT model. Not that the financing decision is a separate analysis from the investment decision.

1. FLEXIBILITY: debt reduces flexibility because in the future, if you want to raise more money, maybe your only option will be equity because you are highly leveraged. On the other hand, equity provides you with flexibility.
2. RISK (leverage): compare with the industry the levels of leverage vs their P/E ratio. If companies highly profitable and with high P/E ratio are more leveraged than you, maybe you’re under leveraged. Also see your times interest ratio to see if your level of financial risk (leverage) is appropriate to your industry.
3. INCOME (EPS): more debt provides a tax shield and increases profitability and EPS.
4. CONTROL: in terms of debt, the bank usually puts you restrictions which can limit your control. Equity stakeholders may take control if they have more than 50% of the shares.
5. TIMING: whether to finance with debt or equity is also a matter of timing, for example, if at that point in time interest rates are low or maybe the price of your stock is too low to raise funds, etc.

Deciding how to finance the company assets is a separate decision. The financial decision and the investment decision for example, are different things and should be considered separately.

In what regards to the financing decision, the main thing to consider is whether to finance with debt or with equity. Debt is less expensive but it is more risky while equity is more expensive and less risky.

See in the following example two companies which have the same Income Statement, they are equally profitable, but they are financed in different ways:

-> Download spreadsheet with example.

In Scenario 1: Company 1 is 20% financed by debt while Company 2 is 80% financed by debt. Therefore, although both companies have an EBIT of US$200, Company 1 has a ROE of 11% while Company 2 has a ROE of 30%. Investors in Company 2 will have a higher return on their investment because the interest payment is before tax, thus interest expense provide a tax benefit over Company 1.

However, Scanario 2 shows how Company 2 is more risky. If EBIT decreases to US$60, Company 1 remains profitable while Company 2 will become unprofitable.

Use common size financial statements (P&L and BS as % of sales), analyze trends and changes.His role is different to that of an accountant or an economist, his objective is to forecast financial needs and make the right decisions in order to maximize shareholders value.

In order to maximize shareholders value the CFO must:

1. Manage working capital (do not run out of cash! -> growth implies working capital requirements)
2. Find the optimal capital structure (what % debt vs what % equity -> risk vs return)
3. Make good investment decisions (invest in projects which have NPV >0 OR IRR>WACC)

The CFO’s guiding equation is:

CORPORATE RISK = FINANCIAL RISK + BUSINESS RISK

-> Never have both financial and business risk high!!

If the company is publicly traded, take care of both earnings and investors confidence.

STOCK PRICE = EPS (earnings) x P/E Ratio (investors confidence)

Important to note that a firm’s main value drivers are -> SALES and GROSS PROFIT.

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WATCH OUT FOR RED FLAGS

1. Seasonality -> high financial risk (don’t forecase w/quarterly information); seasonality requires conservative financial policies although there is a trade-off between efficiency and financial risk.
2. Net Profit VS Cash Generated from Operations
3. Using short-term to finance long-term needs
4. EPS vs Net Profit (are they issuing new shares?)
5. Changes in Gross Margin -> reflection of competition
6. Changes in Operating Expenses -> reflection of economies of scale or efficiencies
7. ROA > WACC -> the company is creating value (watch out to include only operating assets in ROA, not strategic assets).
8. ROE = indication of how well is the company financial structure (leverage)
9. Assume mean regression (trend is to go towards the mean)
10. Profitability is different to liquidity, a profitable company can go bankrupt, or maybe the company is losing ownership and control bc needs to issue new shares, etc.
11. Growth is a problem for the CFO
12. Respond quickly to recesion -> is sales are going down, take inventory and payables down quickly too
13. A good financial policy can be a source of competitive advantage
14. INFLATION: it is an additional form of growth that will add financing needs and will also increase company costs.

RULES OF THUMB

1. Average risk premium = 4 to 6%
2. Average P/E ratio = 15
3. Average Annual growth = 3.2%
4. Average Risk Free = 3%

TOOLS

• Use common size financial statements (P&L and BS as % of sales), analyze trends and changes.
• CAGR = (sales y5 / sales y1) potencia 1/4 – 1
• Understand segment reporting
• Watch out for seasonalities
• % change = y2 – y1 / y1

1. Liquidity: is the company capable of paying for its short-term financial needs?

• Current ratio = current assets / current liabilities -> (>2)
• Acid test = c. assets – inventories / c. liabilities -> (>1)
• Days Receivables = average receivables btw BS1 AND BS2 / sales per day (sales/365) ; are you collecting what you sold?
• Days Inventory = average inventory btw BS1 AND BS2 / cost of sales per day (CofS/365) ; are you selling?
• Days Payables = average payables btw BS1 AND BS2 / purchases per day (from Manuf. Account/365) ; are you delaying payments to suppliers?
• Cash Conversion Cycle = Days Receivables + Days Inventory – Days Payable

Working Capital Management and see trends in Receivables, Inventory and Payables (as a % of sales) and ask yourself a) is the company collecting payments ok in comparison to the industry? and b) is growth killing them? i.e. if the company is growing very quickly? Because growth in sales implies a growth in working capital, for a CFO growth is a problem because he needs to find sources of financing. Inventory and receivables grow proportionately to sales, so you will need current liabilities to grow as well to finance them.

2. Solvency: is the company going to be able to pay its creditors?

• Leverage = long-t debt / long-t debt + equity
• Times Interest = interest / net profit

3. Profitability

• Gross Profit
• Net Profit
• ROA: best profitability measure, if ROA>WACC -> the company is creating value; but watch out for strategic assets, only take into account of ROA = Net Profit / Operating Assets (only operating assets, not strategic such as excess cash, etc).
• ROE: it’s not a profitability ratio, it is an indication of how good a company is financing itself, because % ROE varies within a same company that has different capital structures (more leverage, more ROE, but more risk too).

CLICK HERE TO DOWNLOAD XLS. EXAMPLE

By using the basis financial statements describes in other posts (Income Statement, Balance Sheet and Cash-Flow), managers can develop pro forma financial statements.

A. Forecast profitability, meaning to develop a pro-forma Income Statement. A firm’s net income depends mainly on 5 variables:

1. Sales (price x quantity) -> it’s the main forecast driver, so be aware of your assumptions and make them explicit.
2. Cost of Goods Sold (the cost of manufacturing or purchasing the firm’s product or services); can be fixed or variable costs; in general it’s a % of sales.
3. Operating Expenses (marketing, distribution, administrative, depreciation and general costs); can also be fixed or variable.
4. Interests
5. Income Tax

B. Forecasting financial needs, requires to develop a pro-forma Balance Sheet.

1. The first step in developing a pro-f0rma Balance Sheet is to determine the amount of assets that the company will require in order to produce its products and services. Most firms will require working capital (inventory, receivables and cash) and fixed-assets (building, machines, cars, computers, etc).
2. The key to effectively forecasting is to understand the firm’s relationship between sales and assets. In general, the greater the firm’s sales, the greater the assets required and in turn, the greater need for financing. Be carefull in determining the working capital needed, it is usually underestimated (and don’t forget to add personal expenses and unexpected items). If the company has no reliable historical information, industry standard ratios or experts’ forecasting feedback can be the basis for determining the assets-to-sales ratio. In general, assets can be determined as a percentage of sales.
3. In general, “cash” is a minimum level which is determined by the company policies. “Receivables” and “Inventory” are a % of sales. Finally, “Fixed Assets and Depreciation” are predictable expenses easy to estimate.
4. The need to invest in assets will determine the amount of financing required. Whether it will be financed with debt or equity is another issue not to be analyzed at this stage. In general, you take into account the firm’s historical financial obligations. Note that “Payables”, are also a % of sales and come either from historical information or from industry averages.

C. Forecasting Cash-Flows, the pro-forma Income Statement and Balance Sheet do not provide with sufficient information about the company’s financial situation. Once the pro-forma Income Statement and Balance Sheet have been developed, we must develop the pro-forma cash-flow statement. This will allow the manager to understand the use and sources of funds; for example, it is possible that in the first year of operations the company can have negative cash flow from operations and its highest challenge is to get cash flows from financing.

Forecasting with INFLATION: inflation is an additional form of growth and at the same time increases the company costs. If your are expecting a growth in sales of 10% and inflation will be 5%, future sales will not be just 15% higher! Because of inflation sales in year 2 will be S2=(S1×1.1)x1.05. Furthermore, as not many companies are capable of passing suppliers increase in price to final customers, inflation will have an impact on cost of sales. Cost of Sales in year 2 will be COGS2= COGS1 x 1.05.

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Notes

• Try making different scenarios (sensitivity forecasting).
• Determine and clearly understand what’s your brake-even point.

Understanding financial requirements flow...