Today s Agenda. DFR1 and Quiz 3 recap. Net Capital Expenditures. Working Capital. Dividends. Estimating Cash Flows

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1 Today s Agenda DFR1 and Quiz 3 recap Net Capital Expenditures Working Capital Dividends Estimating Cash Flows

2 Net Capital expenditures Net capital expenditures = capital expenditures - depreciation Depreciation may be considered a cash inflow that pays for some, or perhaps all, capital expenditures. In general, net capex = f(growth, E(growth)) High growth firms are expected to have higher net capex than low growth firms. Net capex includes: R&D expenses (after being capitalized) Adj. net capex = Net capex + current year s R&D expense Amort. of Research Asset Acquisitions of other firms Adj. net capex = Net capex + Acquisitions of other firms - Amort. of such acquisitions Note: firms do not necessarily do acquisition every year, therefore a normalized acquisition measure should by employed. Acquisitions may be found in the Cash Flow statement.

3 Net Capital expenditures Example (2014 Cisco Systems, Inc.) Cap Expenditures (from statement of CF) $1,275 - Depreciation (from statement of CF) (2,432) Net Cap Ex (1,157) + R & D expense (10-k) 6,294 - Amortization of R&D (own calculation) (1,818) + Acquisitions 3,181 Adjusted Net Capital Expenditures 6,500

4 Working Capital investments From an accounting perspective: Working capital = current assets - current liabilities Current assets include inventory, cash, A/R, etc. Current liabilities include A/P, short-term debt, LT debt due within one year, etc. From an economic (cash flow) perspective: Working Capital = non-cash current assets - non-debt current liabilities Note: Any investment of working capital ties up cash. Therefore, increases (decreases) in working capital will reduce (increase) cash flows in that period. When forecasting future growth, it is important to estimate the effects of such growth on working capital needs, and to build these effects into forecasted cash flows.

5 Working Capital investments Why back out cash (and other marketable securities)? The instruments are typically invested by firms in treasury bills, short term government securities or commercial paper. While the return on these investments may be lower than what the firm may make on its real investments, they represent a fair return for riskless investments. Unlike inventory, accounts receivable and other current assets, cash then earns a fair return and should not be included in measures of working capital. Are there exceptions to this rule? When valuing a firm that has to maintain a large cash balance for day-to-day operations or a firm that operates in a market in a poorly developed banking system, you could consider the cash needed for operations as a part of working capital. Why back out all interest bearing debt, short term debt, and the portion of long term debt that is due in the current period from the current liabilities? This debt will be considered when computing cost of capital and it would be inappropriate to count it twice.

6 Working Capital investments General principles Volatility Changes in non-cash working capital from year to year tend to be volatile. A far better forecast of future non-cash working capital needs can be estimated by looking at non-cash working capital as a proportion of revenues Dealing with negative working capital Some firms have negative non-cash working capital. While these firms certainly can generate positive near-term future cash flows, assuming negative non-cash working capital into perpetuity is not feasible. A better approach (when dealing with firms with negative non-cash WC) would be to set non-cash working capital needs to zero.

7 Dividends and Cash Flow to Equity Strictly speaking, the only cash flow investors receive from an equity investment in a publicly traded firm is the dividend that will be paid on the stock. Managers set actual dividends paid distributed dividends may be much lower than the potential dividends managers are conservative and try to smooth out dividends managers often hold on to cash to meet unforeseen future contingencies and investment opportunities Note: when actual dividends are less than potential dividends, using a model that focuses only on dividends will understate the true value of equity in a firm.

8 Dividends and Cash Flow to Equity What are potential dividends? The potential dividends of a firm are the cash flows left over after the firm has made any investments it needs to make to create future growth and net debt repayments Are earnings a good proxy for potential dividends? NO!!! Some analysts assume that the earnings of a firm represent its potential dividends. This cannot be true for several reasons: Earnings are NOT cash flows! Earnings contains both non-cash revenues and expenses Even if earnings were cash flows, a firm that paid its earnings out as dividends would not be investing in new assets and thus could not grow Valuation models, where earnings are discounted back to the present, will misestimate the value of the equity in the firm

9 Estimating Cash Flows: FCFE Cash Flows to Equity for a Levered Firm: Net Income - (Capital Expenditures - Depreciation) - Changes in non-cash Working Capital - (Principal Repayments - New Debt Issues) Free Cash Flow to Equity

10 Estimating Cash Flows: FCFE When leverage is stable: Net Income - (1- Debt/capital ratio) (Capital Expenditures - Depreciation) - (1- Debt/capital ratio) Working Capital Needs Free Cash flow to Equity For this firm, proceeds from new debt issues = Principal Repayments + Debt/capital ratio (Capital Expenditures - Depreciation + Working Capital Needs) In computing FCFE, the book value debt to capital ratio should be used when looking back in time but can be replaced with the market value debt to capital ratio, looking forward.

11 Estimating Cash Flows: FCFE Example: Consider the following per share information for TGI, Inc. for 2013: EPS: $4.75 Investment in fixed capital: $1.20 Depreciation: $0.65 Investment in WC: $0.95 TGI is currently operating at target debt/capital ratio of 30%. Shareholders require a 14% return on investment. Expected growth rate is 6% What is the TGI s FCFE? $ (1-30%) ( ) - (1-30%) (0.95) $3.70 What is the value of TGI s stock? Equity value per share = ($3.70 * 1.06) / ( ) Equity value per share = $65.37

12 Reminders Draft 2 due by 10:00pm Monday Feedback due by 10:00pm Wednesday Revision 2 due by 10:00pm Friday

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