Chapter 3 Paper Notes

differentiate between accounting income and cash flow.

Given that managers are charged with maximizing cash flows (not accounting profit) to maximize LT value to shareholders, we must:

Understand cash flow. Purpose is to evaluate projects to determine whether the future increases in FC are sufficient to more than offset the initial project cost. Used in capital budgeting analysis (CH 11).

Net Working Capital (NWC)

= Current Assets - Current Liabilities Or CA - CL

Net Operating Wkg Capital (NOWC)

= Current Assets - (Current Liabilities - Short Term Debt or Notes Payable)

YOU MUST LEARN HOW TO DEVELOP A CASH FLOW STATEMENT!!

Developing cash flow statement:

Cash flow from Ops + Cash flow from Investing Activities (think P,P & E) + Cash flow from Financing Activities

Net Inc + Non-cash Adjustments (think Depreciation and Amort.) + Changes in Curr. Assets and Curr. Liabilities

Hints for Changes in Current Assets and Current Liabilities—

Did the change year over year result in more money in your checking account or less? If less, then a USE; if more, then a SOURCE. Pages 70-72 of the book have a useful review of these changes.

SECURITY ANALYSIS USAGE

- an FYI. For purposes of the class, we use Cash Flow as calculated above (the text book definition), but I want you to know of, be aware of, industry usage:

EBIT =

earnings before interest and taxes

EBITDA

= EBIT + Depreciation and Amortization

EBITDA often used in financial analysis as a quick assessment / surrogate of earnings or cash flow from operations. It is before purchases of equipment (Investing Activities) and Financing. It assumes that changes in working capital are roughly the same year to year and are managed efficiently.

Free Cash Flow for most Street Analysts is

FCF = EBITDA - Capital Expenditures NOTE: this FCF is BEFORE Financing Activities

**The book defines FCF as the amount of cash that could be withdrawn without harming a firm's ability to operate and to produce future cash flows. A positive FCF indicates that the firm is generating enough cash to finance current investments in fixed assets and working capital. In contrast, negative cash flow means that the company does not have sufficient internal funds to finance investments in fixed assets and working capital and that it will have to raise new money to pay for these investments. NEGATIVE FCF may not be bad-one is motivated to ask more questions. E.g., Is this a growth company?

FCF

= (After-tax EBIT + D&A) - (Capital Expenditures + Change in NOWC)

Market Value Added:

Market Value of equity less the book equity value:

MVA = Sum MV Shares Outstanding - Bk Equity

SARBANES-OXLEY (2002)

     requires company CEO and CFO to certify that financial statements were prepared properly.

Understand the risks associated with compensating managers on the ST results vs. the LT results.

Understand the taxation of Dividends and Interest. Interest is deducted from operating income pre-tax income. Dividends cannot be deducted. Therefore, the corporation tax system favors debt over equity financing (interest expense saves on taxes paid as it reduces pre-tax income).

To pay $1 in dividends, a company must earn pre-tax income of $1/(1-tax rate).

If tax rate is 40%, then $1/(1-0.4) or $1/0.6 or $1.67 of pre-tax income. Dividends are taxable to the recipient-results in DOUBLE TAXATION.