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Prepared by: Nir Yehuda

With contributions by

Stephen H. Penman – Columbia University

Peter D. Easton and Gregory A. Sommers - Ohio State University

Luis Palencia – University of Navarra, IESE Business School

What you will learn from this Chapter

- What is meant by cash flow from operations
- What is meant by cash used in investing activities
- What is meant by free cash flow
- How discounted cash flow valuation works
- Problems that arise in applying cash flow valuation
- Why free cash flow may not measure value added in operations
- Why free cash flow is a liquidation concept
- How discounted cash flow valuation involves cash accounting for operating activities
- Why “cash flow from operations” reported in U.S. financial statements does not measure operating cash flows correctly
- Why “cash flows in investing activities” reported in U.S. financial statements does not measure cash investment in operations correctly
- How accrual accounting for operations differs from cash accounting for operations
- The difference between earnings and cash flow from operations
- The difference between earnings and free cash flow
- How accruals and the accounting for investment affect the balance sheet as well as the income statement
- Why analysts forecast earnings rather than cash flows
- How a valuation model is a model of accounting for the future

C1

C3

C4

C5

C2

I4

I1

I2

I3

I5

C3-I3

C1-I1

C4-I4

C5-I5

C2-I2

1

2

3

4

5

Cash Flows for a Going ConcernFree cash flow is cash flow from operations that results from investments minus cash used to make investments.

- Cash flow from operations (inflows)
- Cash investment (outflows)
- Free cash flow
- Time, t

The Continuing Value for the DCFM

A. Capitalize terminal free cash flow

B. Capitalize terminal free cash flow with growth

Will it work?

DCF Valuation: New York State Electric and Gas

Simple Valuations

- Simple valuations make valuations solely from information in the financial statements. They avoid analysis and avoid forecasting. They can work, but beware !
A simple DCF valuation for NY State Electric and Gas, 1996

Another simple valuation

where g is a growth rate

(Fiscal years ending January 31. Amounts in millions of dollars.)

1988

1989

1990

1991

1992

1993

1994

1995

1996

Cash from operations

536

828

968

1,422

1,553

1,540

2,573

3,410

2,993

Cash investments

627

541

894

1,526

2,150

3,506

4,486

3,792

3,332

Free cash flow

(91)

287

74

(104)

(597)

(1,966)

(1,913)

(382)

(339)

Dividends per share

0.03

0.04

0.06

0.07

0.09

0.11

0.13

0.17

0.20

Price per share

6⅞

8½

10⅝

16½

27

32½

26½

25⅞

24⅜

The DCFM: Will it work for Wal-Mart Stores?Why Free Cash Flow is not a Value-Added Concept

- Cash flow from operations (value added) is reduced by investments (which also add value): investments are treated as value losses
- Value received is not matched against value surrendered to generate value - except for long forecast horizons
Note: a firm reduces free cash flow by investing and increases free cash flow by reducing investments:

free cash flow is partially a liquidation concept

Note: analysts forecast earnings, not cash flows

Easy concept: cash flows are “real” and easy to think about; they are not affected by accounting rules

Familiarity: is a straight application of familiar net present value techniques

Disadvantages

Suspect concept:

free cash flow does not measure value added in the short run; value gained is not matched with value given up.

free cash flow fails to recognize value generated that does not involve cash flows

investment is treated as a loss of value

free cash flow is partly a liquidation concept; firms increase free cash flow by cutting back on investments.

Forecast horizons: typically requires forecasts for long periods; terminal values for shorter periods are hard to calculate with any reliability

Validation: it is hard to validate free cash flow forecasts

Not aligned with what people forecast: analysts forecast earnings, not free cash flow; adjusting earnings forecasts to free cash forecasts requires further forecasting of accruals.

Discounted Cash Flow Analysis: Advantages and Disadvantages- When It Works Best
- When the investment pattern is such as to produce constant free cash flow or free cash flow growing at a constant rate.

Statement of Cash Flows: Dell Computer

Reported Cash Flow from Operations

Reported cash flows from operations in U.S. cash flow statements is after interest:

Cash Flow from Operations =

Reported Cash Flow from Operations + After-tax Net Interest Payments

After-tax Net Interest = Net Interest x (1 - tax rate)

Net interest = Interest payments – Interest receipts

Reported cash flow from operations is sometimes referred to as levered cash flow from operations

Reported Cash Flow in Investing Activities

Reported cash investments include net investments in interest bearing financial assets (excess cash):

Cash investment in operations =

reported cash flow from investing

- net investment in interest-bearing securities

Calculating Free Cash Flow: Dell Computer, 2002

Reported cash flow from operations 3,797

Interest payments 31

Interest income* (314)

Net interest payments (283)

Taxes (35%) †99

Net interest payments after tax (65%) (184)

Cash flow from operations 3,613

Reported cash used in investing activities 2,260

Purchases of interesting-bearing securities 5,382

Sales of interest-bearing securities (3,425) 1,957

Cash investment in operations 303

Free cash flow 3,310

*Interest payments are given as supplemental data to the statement of cash flows, but interest receipts usually are not. Interest income (from the income statement) is used instead; this includes accruals but is usually close to the cash interest received.

†Dell’s statutory tax rate (for federal and state taxes) is 35 percent, as indicated in the financial Statement footnotes.

Forecasting Free Cash Flows

- It is difficult to forecast free cash flows without forecasting earnings. First forecast earnings and then make adjustments to convert earnings to cash flow from operations. Follow the following steps:
- Forecast earnings available to common
- Forecast accruals (the difference between earnings and cash flow from operations in the cash flow statement)
- Calculate levered cash flow from operations (Step (i) - Step (ii))
- Calculate unlevered cash flow from operations by adding after-tax net interest
- Forecast cash investments in operations
- Calculate forecasted free cash flow, C - I (Step (iv) - Step (v))

2000

2001

2002

Earnings

1,666

2,177

1,246

Accrual adjustment

2,260

2,018

2,551

Levered cash flows from

operations

3,926

4,195

3,797

Interest payments

34

49

31

Interest receipts

(158)

(305)

(314

)

Net interest payments

(124)

(256)

(283)

Tax at 35%

43

(81)

9

0

(166)

99

(184)

Cash flow from operations

3,845

4,029

3,613

Cash investment in operations

(401

)

(482)

(303)

Free cash flow

3,444

3,547

3,310

Forecasting Free Cash Flow: Dell ComputerFeatures of the Income Statement

1. Dividends don’t affect income

2. Investment doesn’t affect income

3. There is a matching of

- Value added (revenues)
- Value lost (expenses)
- Net value added (net income)
4. Accruals adjust cash flows

Accruals

Value added that is not cash flow

Adjustments to cash inflows that are not value added

The Revenue Calculation

Revenue = Cash receipts from sales

+ New sales on credit

Cash received for previous periods' sales

Estimates of credit sales not collectible

Estimated sales returns and rebates

Deferred revenue for cash received in advance of sale

+ Revenue previously deferred

The Expense Calculation

Expense = Cash paid for expenses

+ Amounts incurred in generating revenue but not yet paid

Cash paid for generating revenues in future periods

+ Amounts paid in the past for generating revenues in the current period

Earnings and Cash Flows

Earnings = [C - I] - i + I + accruals

= C - i + accruals

- The earnings calculation adds back investments and puts them back in the balance sheet. It also adds accruals.

Earnings and Cash Flows: Wal-Mart Stores

Accruals, Investments and the Balance Sheet

Accruals and investments are put in the balance sheet

Shareholders’ equity = Cash + Other Assets - Liabilities

Earnings

Cash from Operations

Accruals

Free cash flow

Cash from Operations

Investments

The articulation of the financial statements through the recording of cash flows and accruals

Net cash flows from all activities increases cash in the balance sheet

Cash from operations increases net income and shareholders’ equity

Cash investments increase other assets

Cash from debt financing increases liabilities

Cash from equity financing increases shareholders’ equity

Accruals increase net income, shareholders’ equity, assets and liabilities

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