Capital returns, cash flow, structure, costs, economic profit

1. Capital
Part 1
Capital 2016 1

2. Topics
• Invested capital
• Return to invested capital
• Cash flow to invested capital
• Capital structure
• Cost of capital
• Economic profit
2Capital 2016

3. Primary Objectives
3
Invested capital
IC = NFA + NWC
IC: book value of invested capital
NFA: Net fixed assets
NWC: Net working capital Start with Fairway
Corp but then
assume that invested
securities, IS, non-
operating cash, and
deferred taxes, T, are
all zero
Capital 2016

4. Primary Objectives
4
Return to invested capital
NOPAT = EBIT·(1 – t) + DT
NOPAT: Net operating profit after tax
EBIT: Earnings before interest and tax
t: Average tax rate
T: Deferred tax
Rate of return on invested capital
Capital 2016

5. Primary Objectives
5
Cash flow to invested capital
FCF = NOPAT – DIC
= NOPAT – DNFA – DNWC
FCF: Free cash flow
k: weighted average cost of capital
V: value of the firm
Capital 2016

6. Primary Objectives
Capital 2016 6
Economic profit
EP = return on invested capital – cost of invested
capital
=( roic – k ) ∙ IC
k: weighted average cost of capital
roic: rate of return on invested capital
IC: book value of the invested capital

7. 7
Balance Sheet
Capital 2016

8. Accounting Principles and Guidelines
8
1. Economic Entity Assumption
2. Monetary Unit Assumption
Economic activity is measured in U.S. dollars, and only
transactions that can be expressed in U.S. dollars are
recorded.
Because of this basic accounting principle, it is assumed
that the dollar's purchasing power has not changed over
time. As a result accountants ignore the effect of inflation on
recorded amounts.
3. Time Period Assumption
4. Cost Principle
5. Full Disclosure Principle
6. Going Concern Principle
7. Matching Principle
8. Revenue Recognition Principle
9. Materiality
10. Conservatism
Capital 2016

9. Balance Sheet Overview
9
Liabilities
Non-interest bearing
Debt
Equity
Assets
Cash
Other
Capital
Capital 2016

10. Balance Sheet
10Capital 2016

11. Balance Sheet Notation
Accounting periods span a period Dt
Dt = ti – ti-1
An account X has value Xi at
time ti and value Xi-1 at time ti-1
The change in account value
over Dt is DX, DX= Xi - Xi-1
11
i-1 i
i+1
ti-1 Dt ti
ti+1
Xi-1 DX Xi
Xi+1
Capital 2016

12. 12
Balance Sheet
Capital 2016

13. Property, Plant, & Equipment
GFAi PPE or gross fixed assets (total cost) at time ti
CX capital expense (“capex”) over ∆t
CG gross cost of PPE sold off over ∆t
GFAi = GFAi-1 + CX – CG
DGFA = CX - CG ti-1
GFAi-1
ti
GFAi
Dt
CX
CG
13Capital 2016

14. Property, Plant, & Equipment
ADi accumulated depreciation on PPE at time ti
DX depreciation expense over ∆t
CC book value (carry cost) of PPE sold off over ∆t
CG gross cost of PPE sold off over ∆t
ADi = ADi-1 + DX – (CG – CC)
CG – CC: Gross cost – carry cost of PPE sold off over Dt
Accumulated depreciation of PPE sold off over Dt
DAD = DX – CG + CC
Accounting income on
the sale of PPE over Dt is
DG = CS – CC
CS is cash received on sale of PPE
14
ti-1
ADi-1
ti
ADi
Dt
DX
CG-CC
Capital 2016

15. Property, Plant, & Equipment
GFAi gross fixed asset (total cost) capital investment at time ti
ADi accumulated depreciation on PPE at time ti
NFAi Net fixed assets (PPE) at time ti
NFAi = GFAi - ADi
∆NFA = DGFA – DAD
= (CX – CG) – (DX – CG + CC)
= CX – DX - CC
15
ti-1
NFAi-1
ti
NFAi
Dt
CX
DX+CC
Capital 2016

16. Invested Capital
Working Capital
WC = CA – CL
= CE + AR + INV – AP – ITP – SD
Net Working Capital (net of cash and short
term debt)
NWC = AR + INV – AP – ITP
DNWC = DAR + DINV – DAP –D ITP
Invested Capital
IC = NFA + NWC
∆IC = ∆NFA + ∆NWC
= CX – DX – CC + ∆NWC
Also called net operating assets
16Capital 2016

17. Invested Capital
∆IC = ∆NFA + ∆NWC
= CX – DX – CC + ∆NWC
If only fully depreciated assets are sold during the period, then
CC= 0, thus
∆IC = CX – DX + ∆NWC
In a steady state operating approximation, CX = DX and
∆NWC = 0, thus
∆IC = 0
17Capital 2016

18. Very Simple Balance Sheet
18
Start with Fairway Corp but then assume that
invested securities, IS, non-operating cash, and
deferred taxes, T, are all zero
Capital 2016

19. Income Statement
19
DG=CS-CC=$20,000-$0
Sales revenues…………………………………………………………...…………………….3,190$ R……………………………. 3,190$ Revenue
Cost of sales…………………………………………...……………………………………….2,290$ COGS 2,290$ Cost of goods sold
Gross margin…………………………………..……………………………………. 900$ GM………………….. 900$ Gross margin
Expenses: OX 449$ Operating expenses
Depreciation…………………………………………… 120$ NX (39)$ Other expenses (income)
Other expenses………………………………………. 477$ *
EBITDA……………………… 490$ Earnings before int, tax, and depre
Income taxes………………………………………….. 103$ 700$ DX 120$ Depreciation expense
Net Income………………………………………..……………………………………………200$ EBIT…………………. 370$ Earnings before interest and tax
IX 67$ Interest expense
Retained earnings, December 31, 2009…………………………………….…………1,640$ ITX 103$ Income tax expense
Add: 2007 net income…………………………………...…………………………….200$ NP……………………………. 200$ Net profit
Less: Cash dividends……………………………………….……………………………..(60)$
Retained earnings, December 31, 2010……………………………………………….…………1,780$ RE2014 1,640$ Previous retained earnings
NP 200$ Net profit
*Net of $20,000 gain on disposal of equipment DIV (60)$ Cash dividends
RE2015 1,780$ Current retained earnings
For the Year Ended December 31, 2015
(in thousands)
FAIRWAY CORPORATION
Income Statement and Statement of Retained Earnings
For the Year Ended December 31, 2015
(in thousands)
FAIRWAY CORPORATION
Income Statement and Statement of Retained Earnings
Capital 2016

20. NP: Net profit
EBIT: Earnings before interest and taxes
IX: Interest expense
IT: Income tax expense, t average income tax rate
NP = EBIT – IX – IT
IT = t ·(EBIT – IX)
= t ·EBIT – t · IX
NP = EBIT – IX – t ·EBIT +t · IX
NP= EBIT(1 – t) – IX(1 – t)
= (EBIT– IX)∙(1 – t)
Net Profit: Return To Equity
Capital 2016 20

21. Return on Invested Capital
NP = (EBIT-IX)·(1 – t) = EBIT·(1 – t) - IX·(1 – t)
Adjust NP to return to invested capital, NOPAT
o Effective interest, IX∙(1-t), had been subtracted out of NP, so add it
back
o Non-operating effective income such as interest and dividends
received, IDI∙(1-t), had been added in, so subtract it out
o Deferred taxes, DT, had been subtracted out with ITX, so add it back since
it accrues to capital
NOPAT = EBIT·(1 – t) – IX·(1 – t) + IX∙(1-t) - IDI∙(1-t) +DT
= (EBIT– IDI) ·(1 – t) +DT
NOPAT is Net Operating Profit After Tax
21Capital 2016

22. Return on Invested Capital
NOPAT = (EBIT– IDI) ·(1 – t) + DT
If no deferred tax increment, DT =0, and no investment income
from non-operating assets, IDI = 0 e.g., say the investment
securities, IS, had paid no dividends
Then
NOPAT= EBIT· (1 – t)
22Capital 2016

23. Income Taxes
23
Income taxed paid out (ITC)
Income taxes payable (ITP)
Income taxes deferred (T)
Income tax expense (ITX)
Capital 2016

24. Profitability Ratios
• Profit margin
o a measure of revenue productivity
o how much net profit, NP, is generated from $1 of revenue, R?
NP
R
=
200
3190
= .0627
24Capital 2016

25. Profitability Ratios
• Return (rate) on assets, roa
o a measure of asset productivity
o how much net profit, NP,
is generated from $1 of
total book value of assets, TA?
roa =
NP
TA
=
200
3436
= .0695
25Capital 2016

26. Profitability Ratios
• Return (rate) on equity, roe
o a measure of equity productivity
o how much net profit, NP, is generated from $1 of total book equity,
EB?
26
roe =
NP
EB
=
200
1823
= .1097
Capital 2016

27. Profitability Ratios
The DuPont formula defines roe as a product of three
ratios to provide insight into 3 aspects of the firm
: net profit margin - How much net profit is produced per $1 of
revenue?
: asset productivity relative to revenue - How much revenue is
produced per $1 of total assets?
: measure of financial leverage - What is the dollar value of firm
assets per $1 of equity?
roe =
NP
EB
=
NP
R
×
R
TA
×
TA
EB
NP
R
R
TA
TA
EB
27Capital 2016

28. Profitability Ratios
net profit margin - How much
net profit is produced per $1 of
revenue?
asset productivity relative to
revenue - How much revenue
is produced per $1 of total
assets?
measure of financial leverage -
What is the dollar value of firm
assets per $1 of equity?
28
roe =
NP
R
×
R
TA
×
TA
EB
=
200
3190
×
3190
2876
×
2876
1823
= .0627×1.109×1.578
= .1097
Capital 2016

29. Profitability Ratios
• Return (rate) on invested capital, roic
o a measure of capital productivity
o how much return, NOPAT, is generated from $1 of invested capital,
IC ?
29Capital 2016

30. Corporate Finance Decisions
30
roic k>
Capital 2016

31. Interest Coverage Ratios
31
Interest Coverage Ratio=
EBIT
IX
For Fairway Corp 2015
Interest Coverage Ratio =
370
67
= 7.57
Capital 2016

32. Ratios
• Balance sheet denominators might be defined as averages
• Example roe
32
roe =
NP
EB
=
200
1823
= .1097
roe =
NP
1
2
EB2015 +EB2014( )
=
200
1
2
1823+2007( )
=.1044
Capital 2016

33. Capital
Part 2
Capital 2016 33

34. 34
Cash Flows in a Company
Assets
Revenue generating
economic resources
‘Invest’ capital in assets
Capital
Debt
Equity
Raise capital
Return capital
Return to retained earnings
Operating
income
EBIT
Interest
expense to
banks and
bondholders
IX
Income tax
expense
ITX
Dividends to
shareholders
DIV
34Capital 2016

35. Statement of Cash Flows
35Capital 2016

36. Cash Flows
36
Net cash from
operating activities
Net cash from
investing activities
Net cash from
financing activities
∆CE = CFO + CFI + CFF
Liabilities
Non-interest bearing
Interest bearing
Deferred tax
Equity
Retained Earnings
Common stock
Assets
Cash & equiv
Capital 2016

37. Cash Flows
37
Net cash from
operating activities
Net cash used
by investing activities
Net cash from
financing activities
Liabilities
Non-interest bearing
Debt
Deferred tax
Equity
Retained Earnings
Common stock
Dividends paid out
Interest paid out
Assets
Cash & equiv
FCF
*Modified to remove effects of non-
operating cash flows and to include
effective interest to debt holders
Capital 2016

38. Free Cash Flow
FCF = CFO* + CFI*
CFO = NP + DX + ∆T –DNWC - DG
CFO* = CFO - IDI∙(1-t) + IX∙(1-t)
= NP + DX + ∆T –DNWC - DG -
-IDI∙(1-t) + IX∙(1-t)
= EBIT ·(1 – t) – IX·(1 – t) +
DX + ∆T - ∆NWC –
DG
-IDI∙(1-t) + IX∙(1-t)
-
= (EBIT – IDI)·(1 – t) + ∆T +
DX - ∆NWC – DG
= NOPAT + DX - ∆NWC – DG
38
At Fairway Corp
• All IDI and IX transactions are
cash not accrual
• IS is a non-operating asset
CFI = -CX + DIS + CS
CFI* = CFI – DIS
= -CX + DIS + CS – DIS
= - CX + CS
Capital 2016

39. Free Cash Flow
FCF = CFO* + CFI*
FCF = NOPAT + DX - ∆NWC – DG - CX + CS
-DG = -CS + CC (from slide 14)
FCF = NOPAT – DNWC – CX + DX + CC
-DNFA = -CX + DX + CC (from slide 15)
FCF = NOPAT – DNWC - DNFA
39Capital 2016

40. Free Cash Flow: Summary
40
FCF = NOPAT – DIC = NOPAT – DNFA – DNWC
NOPAT = EBIT·(1 – t) +DT
DNFA = CX – DX - CC
DNWC = DAR + DINV – DAP – DITP
If DT = 0 and CC = 0 (no change in deferred taxes and sell only fully
depreciated assets)
FCF = EBIT·(1 – t) + DX – CX – DNWC
If DX = CX and DNWC = 0 (steady state)
FCF = EBIT·(1 – t)
Capital 2016

41. Investment Decisions
Free cash flow is cash flow in excess of that required to fund all
projects that have positive net present values when
discounted at the relevant cost of capital. Conflicts of interest
between shareholders and managers over payout policies
are especially severe when the organization generates
substantial free cash flow. The problem is how to motivate
managers to disgorge the cash rather than investing it at
below the cost of capital or wasting it on organizational
inefficiencies.
Jensen, Michael C., "Agency Cost Of Free Cash Flow, Corporate
Finance, and Takeovers" . American Economic Review, Vol. 76, No.
2, May 1986.
41

42. 42
R3,190$R3,190$R3,190$
DAR(87)$IDI19$IDI19$
RC3,103$COGS(2,290)$COGS(2,290)$CFI(298.00)$
IDI19$OX(449)$OX(449)$
COGS(2,290)$DG20$DG20$CFO228.00$
OX(449)$DX(120)$DX(120)$CFO*259.68$
DINV(47)$EBIT370$EBIT370.00$31.68$
DAP56$IX(67)$IT(103)$
COGSC+OX(2,730)$IT(103)$IX∙t(22.78)$CFI(430.00)$
IX(67)$NP200$t∙EBIT(125.78)$CFI*(520.32)$
IT(103)$DX120$IDI(19)$(90.32)$
DT5$DG(20)$IDI∙t6.46$
DITP1$DT5$DT5$DCE96.00$
ITC(97)$DAR(87)$NOPAT236.68$
CFO228$DINV(47)$FCF(260.64)$
DAP56$
DITP1$
DNWC(77)$
CFO228$
IDI(19)$IDI(19)$
IDI∙t6.46$IDI∙t6.46$
IDI∙(1-t)(12.54)$IDI∙(1-t)(12.54)$
IX67$IX67$CX(500)$
IX∙t(22.78)$IX∙t(22.78)$DX120$
IX∙(1-t)44.22$IX∙(1-t)44.22$CS20$
DG(20)$
CFO*259.68$CFO*259.68$CC-$
DAR(87)$
CX(500)$CX(500)$DINV(47)$
DIS50$DIS50$DAP56$
CS20$CS20$DITP1$
-DIS(50)$-DIS(50)$DOCE(40.32)$
DOCE(40.32)$DOCE(40.32)$DOWC(117.32)$
CFI*(520.32)$CFI*(520.32)$DIC(497.32)$
FCF(260.64)$FCF(260.64)$FCF(260.64)$
DirectCashFlowIndirectCashFlowIncomeStatementCashFlowFrom
Financing

43. Book and Fair Value
43Capital 2016

44. 44
Book Value of
invested capital, IC,
(operating assets)
NWC +
NFA
Market or Fair
Value, V, of
invested capital,
IC
$
From balance
sheet
From present
value of future
cash flows
discounted at
cost of capital
V= D+E
=
FCFi
(1+k)i
i=1
N
å
Market or Fair
Value of debt, D,
and equity, E
Capital 2016

45. Economic Profit
EP = ( roic – k ) ∙ IC
k is the cost of capital
roic is the rate of return on invested capital
IC is the book value of the invested capital
Return on invested capital = roic ∙ IC = NOPAT
Cost of capital = k ∙ IC
EP = NOPAT – k ∙ IC
Capital 2016 45

46. Market Value Added
C = DB + EB
V = IC + MVA
V is the market value of the company
MVA is the market value added
Recall our previous DCF method of firm value
MVA =
EPi
(1+k)i
i=1
N
å
V=IC+
EPi
(1+k)i
i=1
N
å
V =
FCFi
(1+k)i
i=1
N
å
Capital 2016 46

47. Harvard VC Case
47Capital 2016

48. Harvard VC Case
48Capital 2016

49. Harvard VC Case
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