Capital

Part 1

2

Topics• Part 1

o Capitalo Invested capitalo Return to capitalo Profitability ratios

• Part 2 o Cash flow to capital: Free cash flow o Capital structureo Cost of capitalo Economic profit

V is the value of capital or net operating asserts FCF is cash flow to capitalk is the annual rate cost of capitalN is number of years

3

Balance Sheet Overview

Liabilities

Non-interest bearing

Debt

Equity

Assets

Cash

OtherCapital

4

Cash Flows in a Company

AssetsRevenue generating economic resources

‘Invest’ capital in assets

CapitalDebt

Equity

Raise capital

Return capital

Return to retained earnings Operating income

EBIT

Interest expense to banks and

bondholdersIX

Income tax expense

ITX

Dividends to shareholders

DIV

4

5

Balance Sheet

Balance Sheet

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Balance Sheet NotationAccounting periods span time Dt

Dt = ti – ti-1

An account X has value Xi at time ti and value Xi-1 at time ti-1

The change in account value over Dt is DX, DX = Xi - Xi-1

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i-1 i i+1ti-1 Dt ti ti+1

Xi-1 DX Xi Xi+1

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Balance Sheet

Property, Plant, & EquipmentGFAi PPE or gross fixed assets (total cost) at time ti

CX capital expense (“capex”) over ∆t

CG gross cost of PPE sold off over ∆t

GFAi = GFAi-1 + CX – CG

DGFA = CX - CG ti-1

GFAi-1

ti

GFAi

DtCXCG

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Property, Plant, & EquipmentADi accumulated depreciation on PPE at time ti

DX depreciation expense over ∆tCC book value (carry cost) of PPE sold off over ∆tCG gross cost of PPE sold off over ∆t ADi = ADi-1 + DX – (CG – CC)

CG – CC: Gross cost – carry cost of PPE sold off over DtAccumulated depreciation of PPE sold off over Dt

DAD = DX – CG + CC

Accounting income on the sale of PPE over Dt is

DG = CS – CC CS is cash received on sale of PPE

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ti-1

ADi-1

ti

ADi

DtDX

CG-CC

Property, Plant, & Equipment

GFAi gross fixed asset (total cost) capital investment at time ti

ADi accumulated depreciation on PPE at time ti

NFAi Net fixed assets (PPE) at time ti

NFAi = GFAi - ADi ∆NFA = DGFA – DAD

= (CX – CG) – (DX – CG + CC)= CX – DX - CC

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ti-1

NFAi-1

ti

NFAi

DtCX -DX -CC

Invested CapitalNet Working Capital

NWC = CA – CL= CE + AR + INV – AP – ITP – SD

Net Operating Working Capital

NOWC = OCE + AR + INV – AP – ITP

DNOWC = DOCE + DAR + DINV – DAP –DITP

Invested Capital (in operations)

IC = NFA + NOWC

∆IC = ∆NFA + ∆NOWC

= CX – DX – CC + ∆NOWC

Also called net operating assets12

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Fairway Corp Balance Sheet

Invested Capital∆IC = ∆NFA + ∆NOWC

= CX – DX – CC + ∆NOWC

If only fully depreciated assets are sold during the period, then CC= 0, thus

∆IC = CX – DX + ∆NOWC

For a steady state operating approximation, CX = DX and ∆NOWC = 0, thus

∆IC = 0

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Balance Sheet For Fairway Corp

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Balance Sheet For Simple Corp Operations

Net Operating

Assets

Invested Capital

Capital

Income Statement

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*DG=CS-CC=$20,000-$0

Return on Invested CapitalProfit, NP, is return to equity (to retained earnings)NP = (EBIT-IX)·(1 – t) = EBIT·(1 – t) - IX·(1 – t) Adjust NP to return to capital, NOPATo Effective interest, IX∙(1-t), was subtracted out of NP, so

add backo Non-operating effective income such as interest and

dividends received, IDI∙(1-t), was added in, so subtract it back out

o Deferred taxes, DT, had been subtracted out with ITX, so add it back since it accrues to capital

NOPAT = EBIT·(1 – t) – IX·(1 – t) + IX∙(1-t) - IDI∙(1-t) +DT = (EBIT– IDI) ·(1 – t) +DT

NOPAT is Net Operating Profit After Tax18

Return on Invested Capital

NOPAT = (EBIT– IDI) ·(1 – t) + DT

If no deferred tax increment, DT =0, and no investment income from non-operating assets, IDI = 0

Then

NOPAT= EBIT· (1 – t)

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Income Taxes

Income taxed paid out (ITC)

Income taxes payable (DITP)

Income taxes deferred (DT)

Income tax expense (ITX)

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Homework 16A • Determine the following quantities for Fairway Corp

• Notes: o During 2015 Fairway Corp sold off some fully depreciated property,

plant and equipment for $20K that originally cost $150K. o Fairway Corp’s only non-operating assets are its investment securities

2014-2015

2015

CX NWCDG NOWCDNFA NFADNOWC IC DIC DB

(debt) ITCNOPAT

ITC = ITX – DT – DITP = 103 – 5 - 1= 97

NOPAT = (EBIT– IDI) ·(1 – t) + DT = 370*(1-.34) + 5 = 249.22

∆IC = CX – DX + ∆NOWC= 500 – 120 + 173= 553

50020

380173552

97249.22

1132125813802638961

Profitability Ratios• Profit margin (rate)

o a measure of revenue productivityo how much net profit, NP, is generated from $1 of revenue,

R?

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Profitability Ratios• Return (rate) on assets, roa

o a measure of asset productivityo how much net profit, NP, is generated from

$1 of total assets, TA?

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Profitability Ratios• Return (rate) on equity, roe

o a measure of equity productivityo how much net profit, NP, is generated from $1 of total book

equity, EB?

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Profitability RatiosThe DuPont formula defines roe as a product of three ratios to provide insight into 3 aspects of the firm

: net profit margin - How much net profit is produced per $1 of revenue?

: asset productivity relative to revenue - How much revenue is produced per $1 of total assets?

: measure of financial leverage - What is the dollar value of firm assets per $1 of equity? 25

Profitability Ratios

net profit margin - How much net profit is produced per $1 of revenue?

asset productivity relative to revenue - How much revenue is produced per $1 of total assets?

measure of financial leverage - What is the value of firm assets per $1 of equity?

For operating and non-operating Fairway Corp assets, revenue, and equity

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Profitability Ratios• Return (rate) on invested capital, roic

o a measure of revenue productivityo how much net profit, NP, is generated from $1 of revenue,

R?

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Financial Decisions at Simple Corp

roic > k

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Homework 16B • Determine the roic for Fairway Corp

o Show calculations

Ratios• Balance sheet denominators might be also be

defined as averages• Example roe

30

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Homework 16C • Determine the following quantities for Fairway

Corpo Use the average balance sheet quantities in the denominator

• roa• roic• roe with DuPont formula

Interest Coverage Ratios

32

Interest Coverage Ratios

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Greater than To Rating12.5 100000 AAA9.5 12.49999

9 AA7.5 9.499999 A+6 7.499999 A4.5 5.999999 A-4 4.499999 BBB3.5 3.999999

9 BB+3 3.499999 BB2.5 2.999999 B+2 2.499999 B1.5 1.999999 B-1.25 1.499999 CCC0.8 1.249999 CC0.5 0.799999 C

0.499999 D

For smaller non-financial service companies with market cap < $ 5 billion

From A. Damodaren’s website