Estimating Cash Flows

Transcription

1 Estimating Cash Flows

2 From accounts to cashflow Assets Liabilities Existing investments Generate cash flows today include long-lived (fixed) and short-lived (wc) assets Assets in Place Debt Fixed claim on cash flows little or no role in management Fixed Maturity tax deductible Expected value that will created by future investments Growth Assets Equity Residual claim on cash flows Significant role in management Perpetual lives

3 Problem with accounting balance figures Influenced by the historical cost of getting asset. Estimate the replacement cost of asset. Not what we want for valuation purposes. Rather, ability to generate future cashflows, either in the future running of the firm or (worst case) price hat can be had for assets by selling them in the market (liquiditation value) Therefore, the prime source of information from accounts: Measures of earnings

4 Problems in using earnings 1. Earnings are not the same as cashflows, even if earnings are measured correctly. 2. Accounting measures of earnings are easily manipulated, confound the problems of going from earnings to cash flows Example: Throughout the 90 s, Microsoft beat analysts earnings expectations 39 out of 40 quarters. Look for 2.1 one-time components 2.2 subsidiaries 2.3 working capital increasing more than revenues 2.4 large swings from one year to the other.

5 From earnings to cashflow Look for: Cashflows after taxes, before debt payments, after reinvestment needs Issues: Effective tax rate tax regulation - starting point - statutory rate tax loss carryforwards international operations tax subsidies

6 Working capital Accounting view: Difference current assets current liabilities Back out for valuation purposes: cash, marketable securities, interest bearing debt

7 Working capital ctd Forecasting working capital When is it necessary to go into detail? ask: are there changes to the firms planned operations that is likely to affect working capital.

8 Free Cash Flow Definition of Free Cash Flow (FCF): The amount of cash a company can distribute to all it s security holders (debt holders, preferred equity holders, warrant holders, equity holders, etc.) To value a company, we need to find the cash flow the company is able to produce consistently over a long horizon. Thus, focus on the cash flow that is generated by regular operating activities. Which FCF to calculate for valuation purposes depend on purpose, reminder of three different methods

9 Enterprise DCF The total enterprise value is given by: TEV 0 = A 0 + T t=1 FCF t (1 + r WACC ) t + TV T (1 + r WACC ) T FCFt is Free Cash Flow in period t TVT is Terminal Value (computed in period T ) rwacc is weighted average cost of capital A 0 is redundant assets The value of common equity is: TEV 0 Value of Debt Value of Preferred Equity etc. That is, the value of common equity is the value of the residual claim

10 Adjusted Present Value (APV) The adjusted present value is given by: T APV 0 = A 0 + where t=1 FCF t (1 + r U ) t + TV T (1 + r U ) T + t=1 r U is cost of equity for an unlevered firm E(interest tax-shield) (1 + r? ) t The last sum on the right hand side is the present value of the interest tax shield. What is the appropriate discount rate for the tax shield? Answer: r? should be somewhere between r B and r U.

11 Equity DCF The value of equity is given by: where S 0 = AE 0 + T t=1 FCFE t (1 + r S ) t + TVE T (1 + r S ) T FCFE t is Free Cash Flow to Equity in period t TVE T is Terminal Value of equity r S is cost of equity (e.g., from the CAPM) AE 0 is redundant assets to equity

12 Calculating FCF (direct method) Sales (revenues) Costs + Amortizations = Earnings before interest, taxes, and amortization (EBITA) Taxes paid on EBITA + Increase in deferred taxes and taxes payable = NOPLAT (Operating profit) + Depreciation Increase in operating working capital Increase in other operating assets (net of operating liabilities) Investments in property, plant, and equipment (capex) Investment in goodwill = Free Cash Flow (FCF)

13 Sales and costs Sale or revenue is unit price times the number of units sold for the period that we are looking at. The costs for the same period is the sum of Costs of goods sold (COGS) Selling, general, and administrative expenses (SG&A) Research and development Depreciation and amortization

14 Amortization Amortization is added back because it is a non-cash expense It is treated differently than depreciation because intangible assets does not depreciate: Since intangibles does not depreciate, we do not subtract amortization when computing NOPLAT. You could argue that goodwill impairment should be treated in the same way as depreciation (goodwill is impaired when a third party justifies a reduction in the value of the goodwill.) To the extent that amortization is tax deductible, it is part of the computation of tax on EBITA.

15 Tax on EBITA Provision for income taxes (from income statement) + Tax shield on interest (Interest expense times marginal tax rate) Tax on interest income (Interest income times marginal tax rate) + Tax on non-operating income = Tax on EBITA Notice that we ignore the tax savings created by interest payments when computing the Free Cash Flow. These tax savings will later be reflected as a reduction in the cost of capital used to discount the Free Cash Flows.

16 Deferred taxes and taxes payable Deferred taxes is computed as the difference between deferred tax liabilities and deferred tax assets. Example: Straight line depreciation in the financial statements and accelerated depreciation for tax purposes. Early on in an asset s life, the actual tax paid is less than it appears in the provision for income tax. This creates a tax liability. Until the government is paid, shareholders require a return on these funds. Thus, Add increase in deferred taxes (relative to provision for income taxes) when computing NOPLAT. Taxes payable are taxes for the current period that is not yet paid. An increase in taxes payable is added back.

17 NOPLAT Net Operating Profit Less Adjusted Taxes (NOPLAT) A measure of after-tax operating profits when all taxes are converted to a cash basis and the interest tax shield is ignored.

18 Depreciation Depreciation is added back when computing FCF since it is a non-cash expense. It is not added back when computing NOPLAT since it does represent wear and tear on the assets used in the operations. This is consistent with using net Property, Plant, and Equipment (i.e., the book value of PP&E) in the definition of Invested Operating Capital.

19 Operating working capital Operating working capital is defined as: Operating current assets less Non-interest bearing current liabilities. Operating current assets: Accounts receivables, Inventories, and necessary cash. Non-interest bearing current liabilities: Accounts payable, and other accrued expenses. Change in working capital = + Change in Accounts receivables + Change in Inventories + Change in necessary cash Change in Accounts payable

20 Other operating assets Other operating assets is computed net of non-interest bearing liabilities. Include deferred expenses

21 Capital expenditures Capital expenditures or investments in property, plant, and equipment Includes expenditures on new fixed assets and replacement fixed assets Should not include extraordinary sales of capital (remember, we are trying to identify the cash flow that will be maintained in the future). Capital expenditures are necessary to generate future cash flows. Should therefore be subtracted from revenues to get Free Cash Flow.

22 Investment in goodwill Goodwill is the difference between then book value of the assets of an acquired company and the purchase price of that company. From one fiscal year-end to another, the book value of goodwill changes as follows: GW t 1 A t + I t = GW t, where GW t 1 is the book value of goodwill at the beginning of period t, A t is goodwill amortization, I t is investment in goodwill, and GW t is the book value of goodwill at the end of period t Thus, investment in goodwill can be computed as follows: GW t + A t GW t 1. It is common to compute FCF both with and without investment in goodwill. If acquisitions are not part of the company s growth strategy, it may better to drop investment in goodwill.

23 Other issues Retirement related liabilities: For unfunded or underfunded plans, treat the liability as interest-bearing debt: Add estimated interests expenses to EBITA Adjust taxes for the tax shield Operating leases Operating leases should be capitalized and put on the balance sheet as debt (i.e., a source of financing). Minority Interest Treat the balance sheet item as quasi equity Treat earnings attributable to minority interests as a financing cost (as an interest expense, adjust taxes on EBIT accordingly)

24 Reconciliating FCF to Net Income (indirect method) Net Income (Profits After Taxes) + Change in Taxes payable + After-tax financial expenses (e.g. interest) After-tax financial income (e.g. interest) = NOPLAT (Operating profit) + Depreciation and other non-cash expenses Increase in operating working capital Increase in other operating assets (net of operating liabilities) Investments in property, plant, and equipment (capex) Investment in goodwill = Free Cash Flow (FCF)

25 Distribution of the FCF Free Cash Flow (this is what you start with) Regular payments Interest (to bondholders and other lenders) Preferred dividend (to holders of preferred stock) Dividend (to holders of common stock) etc. Capital market transactions Debt retirement Share repurchases + New financing: bank debt, bond issues, equity issues + Exercise of warrants etc. = Change in cash and cash equivalents (this is what you end up with)

26 Exercise Statement of Income 3,900 4,200 Sales 3,000 2,700 Operating expenses (excl. depreciations) Depreciations Interest expenses Dividends 4, Capital expenditures Consolidated Balance Sheet ,500 Cash and marketable securities 2,000 2,000 Debt (book value) 1,500 11,500 Common equity (book value) Accounts receivables Inventory Accounts payable 45 0 Taxes payable

27 The tax rate is 35%, the amount of necessary cash as a percentage of sales is 1.0%. 1. Compute the Free Cash Flow for year 2001

28 Income statement Sales Operating Expences(excl depr) Depreciations Interest expenses Dividends Capital expenditures

29 Consolidated Balance sheet Cash and marketable securities Debt(book value) Common equity(book value) Accounts receivables Inventory Accounts payable Taxes payable 45 0

30 Direct method Earnings before Interest, taxes and amortizations (EBITA) Taxes Increase in deferred taxes -45 NOPLAT Depreciation increase in operating working capital -7 -increase in other operating assets -investment in property, plant, equipment (capex) 100 -investment in goodwill Free Cash Flow 1047

31 Indirect method Taxable income 0 Taxes 0 Change in taxes payable -45 After-tax financial expences 585 NOPLAT 540 +Depreciation 600 -increase in operating working capital -7 -increase in other operating assets -investment in property, plant, equipment (capex) 100 -investment in goodwill Free Cash Flow 1047

32 Note: Working Capital calculation change Necessary cash as a percentage of sales: change in accounts receivable 40 change in accounts payable 50 sum -7 My calculation is shown in the spreadsheet fcf example

33 United Parcel Service, Inc. (UPS) Visit the web site: Try to find out the following: What information do companies provide in a 10-K report? Find the K report for United Parcel Service (UPS). Compute the 2003 Free Cash Flow for UPS.

34 NOPLAT and FCF Revenue (F-4) 33, Compensation (F-4) (19,328.00) - Other (Note 13, F-31) (9,712.00) + Amortization = EBITA 4, Increase in ongoing provisions/reserves = Adjusted EBITA 4, Taxes on EBITA (1,508.05) + Increase in deferred taxes and taxes payable = NOPLAT 3, Depreciation 1, Change in working capital (198.00) - Change in other operating assets (926.00) - Capex (cash flow statement, F-7) (1,947.00) - Investment in intangibles (224.00) = FCF 1,649.95

35 Reconciliating NOPLAT to Net Income Net Income 2, (A) Add items that are not in Net Income, but that is added to get NOPLAT/FCF + Ongoing provisions/reserves Increase in deferred taxes (B) Items that are incuded in the computation of NOPLAT/FCF + Net interest after tax Amortization (C) Items that are incuded in the computation of Net Income but not in the computation of NOPLAT/FCF + Gain in redemption of long-term debt (28.00) You would also deal with e.o. items here NOPLAT 3,526.95

36 Tax on EBITA Provision for income tax 1, (Note 14, F-32) + Tax shield on interest expense (Note 14, F-32)(Income statement) - Tax effect of investment income (6.30) (Note 14, F-32)(Income statement) = Tax on EBITA 1, Note: Assuming 35% marginal tax rate. See Note 14.

37 Increase in Deferred taxes (Note 14, F-35) Deferred tax liability 4, , Deferred tax asset 2, , Net tax liability 2, , Increase in deferred tax liability Increase in taxes payable

38 Depreciation and amortization Depreciation and amortization 1, (cash flow statement, F-7) Amortizations: Intangibles (Note 6, F-22) 9.00 Capitalized leases (Note 8, F-24) Amortization of benefit plans obligations(f-20) Capitalized software? Capitalized interest payments during construction? (F-9) Amortization Depreciation 1,418.00

39 Ongoing reserves Insurance reserves (Note 9, F-25) Increase in insurance reserves

40 Operating working capital Increase in Account receivable, subtract (264.00) Increase in Account payable, add 66.00

41 Other operating assets Decrease in other current assets, add Increase in prepaid pension costs, subtract (990.00) Increase in accrued (non-paid) wages, add Increase in other current liabilities, subtract (32.00)

42 Goodwill and intangible assets Goodwill and intangible assets 1, , Amortization Investment in intangibles

43 Net interest after tax Interest expense 121(1-0.35) Interest income -18(1-0.35) (11.7) Net interest after tax 66.95

44 Calculating FCFE Sales (revenues) Costs (excluding depreciation) Change in working capital Interest Provision for income taxes (from income statement) = Cash Flow from Operations Investments in property, plant, and equipment (capital expenditures + Proceeds from new debt and preferred equity issues Preferred dividends Debt repayments = Free Cash Flow to Equity (FCFE)

45 Forecasting FCF The value of a company is the discounted value of future cash flows. Thus, FCF needs to be forecasted. Forecasts are made by forecasting sales or sales growth for a period of 5 to 15 years. Proforma balance sheet and income statements for the first 5 years Only main components of the FCFs for the remaining 5 to 10 years (or say 5 10 and then with different growth rates). Other items are typically forecasted using the historical relationship to sales. Most important: Cost margins. Cash flows beyond the forecasting horizon is captured by the Terminal Value

46 Terminal value (continuing value) Our forecast only extends a limited number of years into the future. This does not mean that the company cease to exist after the last year of the forecast. To account for the free cash flows beyond the last year in our forecast, we add a terminal value to the last element of our free cash flow forecast. Gordon growth model Value multiple (exit multiple) (see later lecture on terminal value)

47 Gordon growth model Assume that the last period Free Cash Flow grow at rate g: TV T = FCF T (1 + g) r WACC g = FCF T +1 r WACC g, where FCF T is the free cash flow we expect the firm to generate in the last period of our forecast, g is the growth rate of free cash flow, and r WACC is the risk-adjusted discount rate.

48 Value multiple (exit multiple) Set the terminal value using a value multiple of EBIT, EBITDA, or some other key value driver (See lecture on multiples.)

49 DCF summary Free Cash Flow (FCF) is the amount of cash a company can distribute to all it s security holders Computing FCF from historical accounting statements is useful as a preparation to build a pro-forma model of future FCFs. More on pro-forma models later... The discounted terminal value will often represent more than 50% of TEV rendering your assumptions about long-term growth and cost of capital as crucial.

50 In theory the equity value computed using the enterprise DCF, APV, and equity DCF should give the same answer. But, in practical applications they rarely will: Enterprise DCF (WACC approach): Useful in most situations. APV: useful in situations where it is important to address the side effects of financing. For example, in highly leveraged transaction the debt-tax shield will often be a major value driver. The APV approach allows you to address this separately. Equity DCF: In general easier to apply the Enterprise DCF approach. In some cases, such as financial institutions, Equity DCF is useful.