Corporate Finance

1. Corporate Finance Class 02 Cash Flow Analysis Daniel Sungyeon Kim Peking University HSBC Business School

2. Class Outline • Cash flow analysis • Accrual accounting. What is the difference between finance and accounting? • Introducing free cash flow concept: a finance’s view of cash flows • Financial cash flows • Sources and uses of cash

3. Motivation • So far, we have seen that valuation involves discounting cash flows. • What determines value of a company or an asset? • Current CF, expected future CFs, and their growth • Risk associated with these cash flows • The questions to be answered: • What kind of cash flows? • Where is the information needed for the calculation of these cash flows?

4. Free cash flow • From the finance point of view, the cash flow of interest is the “free” cash flow (FCF). • FCF is the cash flow generated from the firm’s continuing operations that is available for distribution (i.e., is “free”) to suppliers of capital, such as shareholders, bondholders, etc. • FCF is unrelated to how the firm finances its operations • It is generated by the firm’s business activities

5. Comments on FCF • It is not the same as the accounting view of cash flow (as it shows up in the “statement of cash flows”). • FCF only relates to the firm’s ongoing business activities or operations. • Financing terms must be excluded (Why?) • Investments unrelated to normal business activity must be excluded.

6. Free Cash Flow • We decompose the valuation of the firm into: • Valuation of the business/operating side of the firm by discounting FCF • Valuation of the financial side of the firm by using financial techniques • FCF is a consequence of the firm’s operating decisions and not of its financing decisions • How to derive FCF? • By using information provided by accountants • Income Statement, Balance Sheet,… • But financial statements do not list FCF • They list assets and liabilities, revenues and expenses • Our objective is to understand how to obtain FCF from firm’s financial statements

7. Finance and accounting differ in cash flow measurements • Financial statements are prepared by accountants according to the accounting principles • Accountants show profit as it is earned: Accrual accounting • Cash outflows can be sorted into current expenses and capital expenses • When computing profit, current expenses are deducted, NOT capital expenses. • Capital expenses are depreciated over time: annual depreciation charges are deducted from profits. • As a result, in accounting’s profit calculation • Profits include some cash flows and exclude others • Profits are reduced by depreciation, which is not a cash flow.

8. FCF vs. Net income • Why does NI differ from FCF? • The income statement: • Records revenues and expenses on accrual basis • Excludes investment in new fixed assets • Includes non-cash expenses (e.g., depreciation) • Includes financing items (e.g., interest)

9. Net income • Sales - Cost of goods sold - Selling, general, and administrative expenses - Depreciation - Interest expenses - Taxes Net income

10. Problems with NI… • Sales include: • Sales on credit: revenue earned but not received • Cost of goods sold (COGS) • Include non-cash items such as depreciation & amortization (D&A) • Include expenses owed but not yet paid • Inventory is expensed when sold not when paid • LIFO (FIFO) could cause expenses to be greater (lower) than actual costs

11. Problems with NI… • Selling, general, and administrative expenses • Include non-cash items such as depreciation & amortization (D&A) • Expenses owed but not yet paid • May purchase fixed assets, capitalized not expensed • Interest expense is a financing item • Taxes • Taxes paid do not necessarily equal tax expenses

12. When net income is derived… Sales Sales on credit, revenue earned but not received Cost of goods sold Include non-cash items such as depreciation & amortization Expense owed but not yet paid Inventory expensed when sold not when paid LIFO causes expense to be greater than actual costs Selling, general, and administrative expenses Include non-cash items such as depreciation & amortization Expenses owed but not yet paid May purchase fixed assets, capitalized not expensed Interest expense A financing item not an operating item Taxes Taxes paid do not always equal tax expense Net Income

13. FCF Calculation • The Direct Method • Starts with Cash Sales and restates the Income Statement to include only cash charges and operating cash flows • The Indirect Method • Starts with Net Income and adjusts for non-cash charges and non-operating cash flows included in Net Income • Both methods yield the same result • Focus on the “Indirect Method” because of its importance and frequent application

14. FCF Calculation • Start with NI • Make the following adjustments: • Operating adjustments (or non-cash adjustments) • Adjustments for non-cash expenses (e.g., depreciation) • Adjustments for changes in net working capital (NWC) • Adjustments for investment in fixed asset • Financial adjustments • Adjustments of after-tax interest

15. General areas of adjustments Net income + Non-cash charges Depreciation Amortization +/- changes in NWC excluding cash, N/P or ST borrowings Account receivables Inventories Other operating current assets Account payables +/- Proceeds for sale of or payment for fixed assets (PP&E) + Taxes expensed but not yet paid + After-tax portion of interest expense - After-tax portion of interest income Free cash flow

16. General areas of adjustments • NOTE: The list on the previous slide is by no means a standard exhaustive list • In general, remember that: • Increases in assets are cash outflows. Why? • Decreases in assets are cash inflows. Why?

17. Intuition behind adjustments • Why add depreciation & amortization? • Because there is no cash outflow as a result of these expenses • Why adjust for changes in NWC? Add/Subtract from NI? • Increase in A/R: credit sales during the year, for which cash has not yet been received • Increase in A/P: credit purchases during the year, for which cash had not been paid yet • Increase in inventory: operating items paid for in cash but not yet expensed. • Why adjust for net investments in PP&E? • Increase in assets → asset purchase • Decrease in assets → asset sale

18. More on NI Adjustments • Acquisitions and dispositions of subsidiaries • Should an acquisition or a sale of a subsidiary be considered as a part of investments in Fixed Assets? • Acquisition of a subsidiary • Include this cost in the FCF calculation because the subsidiary will contribute to future cash flows • Sale of a subsidiary • Disposition of subsidiaries should be included ONLY if it is part of a firm’s RECURRING business activities

19. One last point: Tax treatment • If a firm takes a charge for depreciation, this non-cash charge is added back in full. • If a firm has interest expense, this non-operating item is added back after-tax.

20. FCF – NI Adjustments • Summary of the adjustments required to derive FCF from NI

21. FCF – NI Adjustments – Example • A firm reported the following results for 2009: • Sales= $59,000, COGS=$22,800, Depreciation= $250, Interest expense= $1,100, Dividends paid= $0 • At the beginning of the year: • GFA= $0, CA= $10,000, CL= $0 • At the end of the year: • GFA= $120,000, CA= $50,900, CL=$31,460 • Effective tax rate is 40% • Compute Net Income and FCF for 2009, assuming that all CA and CL pertain to operations

22. Free cash flow example

23. Why do we need to adjust net income in order to arrive at free cash flow? • Net income reflects non-cash expenses and revenues • Depreciation, amortization • Costs expensed but not yet paid • Sales recorded but not received in cash, etc. • Net income excludes some cash inflows or outflows • Purchases of operating assets • Cash inflow from collecting credit sales(A/R) of last year • Cash outflow from paying off payables to suppliers occurred last year (A/P), etc. • Net income reflects financial cash flows.

24. FCF computation: Important note • The textbook discusses several alternative ways to compute FCF. • Our method is referred to as “indirect method” • We will ignore all other methods, because they are not that important. • I expect you to be thorough on the method we have learned. • i.e., computing FCF starting from NI.

25. Note: Statement of cash flows • Apart from the income statement and balance sheet, companies also report a “statement of cash flows,” which records the sources and uses of funds, and reconciles cash balances. • We will skip a discussion of this statement • Note: the statement of CFs reports an item called the “CF from operating activities” • This is NOT the same as FCF • How is the CF from operating activities different from FCF? • Omits cash flows related to investment necessary for operations (e.g., PP&E) • Includes non-operating expenses and income (example: interests) • FCF can also be derived by making adjustments to the statement of CF, but we will focus on using primarily the balance sheet and income statement to derive FCF.

26. How are FCFs used? • Free cash flows are funds available to pay security holders • Examples: debt holders, stockholders, warrant holders, convertible bond holders • Any specific cash flows paid to the security holders are the financial cash flows • Interest and principle payment, dividend, share repurchase • When FCF is negative, need a financial inflow • E.g., new equity / debt issue • Therefore, FCF reflects the separation between investment decisions and financing decisions • FCF – financial cash flows = the change in cash over the period

27. The connections • Free cash flows are funds generated by the firm’s business • Financial cash flows are the funds distributed to the security holders of the firm • The difference between the two funds is the change in cash over the period

28. FCF and financial cash outflow • FCF – net financial cash outflow = change in cash balance over that period • If FCF<0 → Cash generated by operations is not enough to fund new investments in PP&E • So firm must either use its existing cash balance • and/or raise new funds (a financial cash inflow) • If FCF>0 → Firm’s operations are generating more cash than is required • So firm must either pay out cash to security holders (a financial cash outflow) • and/or add to its existing cash balance

29. Example • FCF • + Financial cash inflows • - Financial cash outflows • = Change in cash balance over that period

30. Free cash flow example

31. What have we learned so far? • Valuing a given stream of cash flows, when the discount rate is known (TVM concepts) • Free cash flow concept • Separation between operation and financing activities • Convert accounting information into finance-based cash flow • Free cash flow is operating cash flow in excess of investments needed for business activity • Next logical step: put these two together to evaluate capital budgeting decisions • What real assets should the firm acquire?

32. For next class • Read RWJ Chapter 10 • Review today’s notes • Make sure you understand: • Barnes and Noble example • Practice problem 2 • In-class examples • If not come and see me!!