Cash Flow And Leverage(1213)
Professor Trainor
12-1
Video: Nickel
Smart Finance
12-2
Cash Flow Versus Accounting Profit
Capital budgeting concerned with cash flow, not accounting profit. To evaluate a capital investment, we must know:
Incremental cash outflows of the investment (marginal cost of investment), and Incremental cash inflows of the investment (marginal benefit of investment).
The timing and magnitude of cash flows and accounting profits can differ dramatically. 12-3
Accountants charge depreciation to spread a fixed asset’s costs over time to match its benefits. Capital budgeting analysis focuses on cash inflows and outflows when they occur.
Cash Flow and Non-Tax Expenses
Non-cash expenses affect cash flow through their impact on taxes: • Compute after-tax net income and add depreciation back, or • Ignore depreciation expense but add back its tax savings.
12-4
Two Methods of Handling Depreciation to Compute Cash Flow
Adding non-cash firm purchases a fixed asset today for Find after-tax profits, add back Assume a expenses back to after-tax earnings non-cash charge tax savings Sales Cost of goods $30,000 (10,000)
$30,000 Sales
$30,000 (10,000)
Cost of goods
Plans to depreciate over 3 years income straight-line Gross profits $20,000 Pre-tax using $20,000 method (40%) Depreciation (10,000) Taxes (8,000)
Pre-tax income $10,000
Firm will Taxes (40%)produce (4,000)
Net income
Costs $1/unit
Aft-tax income Depreciation tax savings Cash Flow
$12,000 $4,000 $16,000
10,000 units/year
$6,000
Sells for $3/unit
Cash flow = NI + deprec
$16,000 12-5
Firm pays taxes at Simplest and most common technique: a 40% marginal rate Add depreciation back in.
Depreciation
Many countries allow one depreciation method for tax purposes and another for reporting purposes.
Accelerated depreciation methods (such as MACRS) increase the present value of an investment’s tax benefits. Relative to MACRS, straight-line depreciation results in higher reported earnings early in an investment’s life.
For capital budgeting analysis, the depreciation method for tax purposes matters most.
12-6
The Initial Investment
Initial cash flows: • Cash outflow to acquire/install fixed assets • Cash inflow from selling old equipment • Cash inflow (outflow) if selling old equipment below (above) tax basis generates tax savings (liability)
An example.... Tax rate = 40% New equipment costs $10 million, $0.5 million to install Old equipment fully depreciated, sold for $1 million
Initial investment: outflow of $10.5 million, and after-tax inflow of $0.60 million from selling the old equipment
12-7
Working Capital Expenditures
Many capital investments require additions to working capital. • Net working capital (NWC) = current assets – current liabilities. • Increase in NWC is a cash outflow; decrease a cash inflow.
Operate booth from November 1 to January 31 Order $15,000 calendars on credit, delivery by Nov 1 Must pay suppliers $5,000/month, beginning Dec 1 Expect to sell 30% of inventory (for cash) in Nov; 60% in Dec; 10% in Jan • Always want to have $500 cash on hand
12-8
• An example…
• • • •
Working Capital for Calendar Sales Booth Nov 1 Dec 1 Jan 1 Feb 1 Oct 1
Cash Inventory Accts payable Net WC $0 0 0 0 $500 15,000 15,000 500 $500 10,500 10,000 1,000 $500 1,500 5,000 (3,000) $0 0 0
0
+3,000
Monthly in WC
Payments and inventory Reduction in inventory Payments Net cash flow
NA
Oct 1 to Nov 1 $0 $0 ($500)
+500
+500
(4,000)
Nov 1 to Dec 1 $4,500 [30%] ($5,000)
Dec 1 to Jan 1 $9,000 [60%] ($5,000)
Jan 1 to Feb 1 $1,500 [10%] ($5,000) ($3,000) 12-9
($500)
+$4,000
Terminal Value
Terminal value is used when evaluating an investment with indefinite life-span:
Construct cash-flow forecasts for 5 to 10 years
Forecasts more than 5 to 10 years have high margin of error; use terminal value instead.
• Terminal value is intended to reflect the value of a project at a given future point in time. • Large value relative to all the other cash flows of the project.
12-10
Terminal Value
Different ways to calculate terminal values:
• Use final year cash flow projections and assume that all future cash flow grow at a constant rate;
• Multiply final cash flow estimate by a market multiple, or
• Use investment’s book value or liquidation value.
JDS Uniphase cash flow projections for acquisition of SDL Inc.
Year 1 $0.5 Billion Year 2 $1.0 Billion Year 3 $1.75 Billion Year 4 $2.5 Billion Year 5 $3.25 Billion 12-11
Terminal Value of SDL Acquisition
Assume that cash flow continues to grow at 5% per year (g = 5%, r = 10%, cash flow for year 6 is $3.41 billion): CF $3.41
PVt
t 1
rg
, or PV5
0.10 0.05
$68.2
• Terminal value is $68.2 billion; value of entire project is:
$0.5 $1 $1.75 $2.5 $3.25 $68.2 $48.67 1 2 3 4 5 5 1.1 1.1 1.1 1.1 1.1 1.1
• $42.4 billion of total $48.7 billion from terminal value • Using price-to-cash-flow ratio of 20 for companies in the same industry as SDL to compute terminal value • Terminal Value = $3.25 x 20 = $65 billion • Caveat : market multiples fluctuate over time
12-12
Incremental Cash Flow
Incremental cash flows versus sunk costs:
Capital budgeting analysis should include only incremental costs.
• An example… • Norman Paul’s current salary is $60,000 per year and he expects it to increase at 5% each year. • Norm pays taxes at flat rate of 35%. • Sunk costs: $1,000 for GMAT course and $2,000 for visiting various programs • Room and board expenses are not incremental to the decision to go back to school
12-13
Incremental Cash Flow
At end of two years assume that Norm receives a salary offer of $90,000, which increases at 8% per year • Expected tuition, fees and textbook expenses for next two years while studying MBA: $35,000 • If Norm worked at his current job for two years, his salary would 2 have increased to $66,150: $60 ,000 1.05 $66 ,150 • Yr 3 net cash inflow: $90,000 - $66,150 = $23,850 • After-tax inflow: $23,850 x (1-0.35) = $15,503 • Yr 4 cash inflow: $90 ,000 1.08 $60 ,000 1.05 3 1 0.35 $18,032 • MBA has substantial positive NPV value if 30 yr analysis period
What about Norm’s opportunity cost?
12-14
Video: Rajan
Smart Finance
12-15
Capital Rationing
Can a firm accept all investment projects with positive NPV?
Reasons why a company would not accept all projects:
Limited availability of skilled personnel to be involved with all the projects;
Financing may not be available for all projects. Companies are reluctant to issue new shares to finance new projects because of the negative signal this action may convey to the market. 12-16
Operating Leverage
12-17
Operating Leverage
Degree of Operating Leverage
The degree of operating leverage (DOL) measures the sensitivity of changes in EBIT to changes in Sales.
A company’s DOL can be calculated in two different ways: One calculation will give you a point estimate, the other will yield an interval estimate of DOL.
Only companies that use fixed costs in the production
process will experience operating leverage.
12-18
Operating Leverage
Degree of Operating Leverage
Effects of Operating Leverage on the Income Statement
Scenario 1 10.0% Net Sales Less: Variable Costs (60% of Sales) Less: Fixed Costs EBIT 378,000 200,000 52,000 Ebit Decreases 35.0% 420,000 200,000 80,000 462,000 200,000 108,000 Ebit Increases 35.0%
12-19
Scenario 2 Unchanged $ 700,000 $
Scenario 3 Sales Increase 10.0% 770,000
Sales Decrease Sales Rem ain $ 630,000
Operating Leverage
Degree of Operating Leverage
Interval Estimate of DOL
DOL = % Change in EBIT = 35% % Change in Sales 10% = 3.50
Because of the presence of fixed costs in the firm’s production process, a 10% increase in Sales will result in a 35% increase in EBIT. Note that in the absence of operating leverage (if Fixed Costs were zero), the DOL would equal 1 and a 10% increase in Sales would result in a 10% increase in EBIT.
12-20
Financial Leverage
Financial leverage results from the presence of fixed
financial costs in the firm’s income stream. Financial leverage can therefore be defined as the potential use of fixed financial costs to magnify the
effects of changes in EBIT on the firm’s EPS.
The two fixed financial costs most commonly found on
the firm’s income statement are (1) interest on debt
and (2) preferred stock dividends.
12-21
Financial Leverage
12-22
Financial Leverage
Degree of Financial Leverage
The degree of financial leverage (DFL) measures the sensitivity of changes in EPS to changes in EBIT. Like the DOL, DFL can be calculated in two different
ways: One calculation will give you a point estimate,
the other will yield an interval estimate of DFL.
Only companies that use debt or other forms of fixed cost financing (like preferred stock) will experience financial leverage.
12-23
Financial Leverage
Degree of Financial Leverage
Effects of Financial Leverage on the Income Statement
Scenario 1 EBIT Dcrease 35.00% EBIT Less: Interest Expense EBT Less: Taxes (30%) Net Incom e EPS (42,000 shares) $ $ 52,000 20,000 32,000 9,600 22,400 0.53 46.67% $ $ Scenario 2 Sales Rem ain Unchanged 80,000 20,000 60,000 18,000 42,000 1.00 $ $ Scenario 3 EBIT Increase 35.00% 108,000 20,000 88,000 26,400 61,600 1.47 46.67% 12-24
EPS Decreases
EPS Increases
Financial Leverage
Degree of Financial Leverage
Interval Estimate of DFL
DFL = % Change in EPS = 46.67% = 1.33 % Change in EBIT 35.00% In this case, the DFL is greater than 1 which indicates the presence of debt financing. In general, the greater the DFL, the greater the financial leverage and the greater the financial risk.
12-25
Total Leverage
Total leverage results from the combined effect of
using fixed costs, both operating and financial, to magnify the effect of changes in sales on the firm’s earnings per share.
Total leverage can therefore be viewed as the total
impact of the fixed costs in the firm’s operating and
financial structure.
12-26
Total Leverage
Degree of Total Leverage
Effects of Combined Leverage on the Income Statement
Scenario 1 10% Sales Decrease Net Sales Less: Variable Costs (60% of Sales) Less: Fixed Costs EBIT Less: Interest Expense EBT Less: Taxes (30%) Net Incom e EPS (42,000 shares) $ $ 378,000 200,000 52,000 20,000 32,000 9,600 22,400 0.53 46.67% $ $ 420,000 200,000 80,000 20,000 60,000 18,000 42,000 1.00 $ $ 462,000 200,000 108,000 20,000 88,000 26,400 61,600 1.47 46.67% $ 630,000 $ Scenario 2 Sales Rem ain Unchanged 700,000 $ Scenario 3 10% Sales Increase 770,000
EPS Decreases
EPS Increases
12-27
Total Leverage
Degree of Total Leverage
Interval Estimate of DTL
DTL = % Change in EPS = % Change in Sales 46.7% 10% = 4.67
In this case, the DTL is greater than 1 which indicates the presence of both fixed operating and fixed financing costs. In general, the greater the DTL, the greater the financial leverage and the greater the financial risk.
12-28
Total Leverage
Degree of Total Leverage
The relationship between the DTL, DOL, and DFL is illustrated in the following equation: DTL = DOL x DFL
Applying this to our example at a sales level of $77, we get:
DTL = 3.50 x 1.33 = 4.6 Which is the same result we obtained using either the point or interval estimates at that sales level.
12-29
Carbonlite Inc. vs. Fiberspeed Corp.
The two firms are in the same industry.
11,000 frames Carbonlite Inc Sales volume Price Total Revenue Fixed costs per year Variable costs per frame Total cost 10,000 sofas $11,000,000 $1,000 $10,000,000 $5,000,000 $9,400,000 $400 $1,600,000 $9,000,000 11,000 frames Fiberspeed Corp 10,000 sofas $11,000,000 $1,000 $10,000,000 $2,000,000 $9,700,000 $700 $1,300,000 $9,000,000
What EBIT
if sales volume$1,000,000 by 10% ? increases $1,000,000
Carbonlite’s EBIT increases faster because it has 12-30 high operating leverage.
Operating Leverage for Carbonlite and Fiberspeed
EBIT Carbonlite Fiberspeed
Sales
Other things equal, higher operating leverage means that Carbonlite’s beta will be higher than Fiberspeed’s beta. 12-31
The Effect of Financial Lev. On Beta
Assets Debt Equity EBIT Interest Cash to equity ROE Firm 1 $100 million $0 $100 million $20 million $0 $20 million 20 ÷ 100 = 20% Firm 2 $100 million $50 million $50 million $20 million $4 million $16 million 16 ÷ 50 = 32%
Case #1: Gross Return on Assets Equals 20 Percent
Case #2: Gross Return on Assets Equals 5 Percent
EBIT Interest Cash to equity ROE $5 million $0 $5 million 5 ÷ 100 = 5% $5 million $4 million $1 million 1 ÷ 50 = 2%
Financial leverage makes Firm 2’s ROE more volatile, 12-32 so its beta will be higher .
Video: Eades
Smart Finance
12-33