ESTIMATING CASH FLOWSadamodar/pdfiles/eqnotes/dcfcf.pdf · 114 Steps in Cash Flow Estimation ¨...
Transcript of ESTIMATING CASH FLOWSadamodar/pdfiles/eqnotes/dcfcf.pdf · 114 Steps in Cash Flow Estimation ¨...
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StepsinCashFlowEstimation
¨ Estimatethecurrentearningsofthefirm¤ Iflookingatcashflowstoequity,lookatearningsafterinterest
expenses- i.e.netincome¤ Iflookingatcashflowstothefirm,lookatoperatingearningsafter
taxes
¨ Considerhowmuchthefirminvestedtocreatefuturegrowth¤ Iftheinvestmentisnotexpensed,itwillbecategorizedascapital
expenditures.Totheextentthatdepreciationprovidesacashflow,itwillcoversomeoftheseexpenditures.
¤ Increasingworkingcapitalneedsarealsoinvestmentsforfuturegrowth
¨ Iflookingatcashflowstoequity,considerthecashflowsfromnetdebtissues(debtissued- debtrepaid)
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MeasuringCashFlows
Cash flows can be measured to
All claimholders in the firm
EBIT (1- tax rate) - ( Capital Expenditures - Depreciation)- Change in non-cash working capital= Free Cash Flow to Firm (FCFF)
Just Equity Investors
Net Income- (Capital Expenditures - Depreciation)- Change in non-cash Working Capital- (Principal Repaid - New Debt Issues)- Preferred Dividend
Dividends+ Stock Buybacks
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MeasuringCashFlowtotheFirm:Threepathwaystothesameendgame
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Where are the tax savings from interest expenses?
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FromReportedtoActualEarnings
Update- Trailing Earnings- Unofficial numbers
Normalize Earnings
Cleanse operating items of- Financial Expenses- Capital Expenses- Non-recurring expenses
Operating leases- Convert into debt- Adjust operating income
R&D Expenses- Convert into asset- Adjust operating income
Measuring Earnings
Firmʼs history
Comparable Firms
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I.UpdateEarnings
¨ Whenvaluingcompanies,weoftendependuponfinancialstatementsforinputsonearningsandassets.Annualreportsareoftenoutdatedandcanbeupdatedbyusing-¤ Trailing12-monthdata,constructedfromquarterlyearningsreports.¤ Informalandunofficialnewsreports,ifquarterlyreportsareunavailable.
¨ Updatingmakesthemostdifferenceforsmallerandmorevolatilefirms,aswellasforfirmsthathaveundergonesignificantrestructuring.
¨ Timesaver:Togetatrailing12-monthnumber,allyouneedisone10Kandone10Q(examplethirdquarter).UsetheYeartodatenumbersfromthe10Q.Forexample,togettrailingrevenuesfromathirdquarter10Q:¤ Trailing12-monthRevenue=Revenues(inlast10K)- Revenuesfromfirst3
quartersoflastyear+Revenuesfromfirst3quartersofthisyear.
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II.CorrectingAccountingEarnings
¨ Makesurethattherearenofinancialexpensesmixedinwithoperatingexpenses¤ Financialexpense:Anycommitmentthatistaxdeductiblethatyouhaveto
meetnomatterwhatyouroperatingresults:Failuretomeetitleadstolossofcontrolofthebusiness.
¤ Example:OperatingLeases:Whileaccountingconventiontreatsoperatingleasesasoperatingexpenses,theyarereallyfinancialexpensesandneedtobereclassifiedassuch.Thishasnoeffectonequityearningsbutdoeschangetheoperatingearnings
¨ Makesurethattherearenocapitalexpensesmixedinwiththeoperatingexpenses¤ Capitalexpense:Anyexpensethatisexpectedtogeneratebenefitsover
multipleperiods.¤ R&DAdjustment:SinceR&Disacapitalexpenditure(ratherthanan
operatingexpense),theoperatingincomehastobeadjustedtoreflectitstreatment.
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TheMagnitudeofOperatingLeases
Operating Lease expenses as % of Operating Income
0.00%
10.00%
20.00%
30.00%
40.00%
50.00%
60.00%
Market Apparel Stores Furniture Stores Restaurants
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DealingwithOperatingLeaseExpenses
¨ OperatingLeaseExpensesaretreatedasoperatingexpensesincomputingoperatingincome.Inreality,operatingleaseexpensesshouldbetreatedasfinancingexpenses,withthefollowingadjustmentstoearningsandcapital:
¨ DebtValueofOperatingLeases=PresentvalueofOperatingLeaseCommitmentsatthepre-taxcostofdebt
¨ Whenyouconvertoperatingleasesintodebt,youalsocreateanassettocounteritofexactlythesamevalue.
¨ AdjustedOperatingEarnings¤ AdjustedOperatingEarnings=OperatingEarnings+OperatingLease
Expenses- DepreciationonLeasedAssetAsanapproximation,thisworks:¤ AdjustedOperatingEarnings=OperatingEarnings+Pre-taxcostof
Debt*PVofOperatingLeases.
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OperatingLeasesatTheGapin2003
¨ TheGaphasconventionaldebtofabout$1.97billiononitsbalancesheetanditspre-taxcostofdebtisabout6%.Itsoperatingleasepaymentsinthe2003were$978millionanditscommitmentsforthefuturearebelow:
Year Commitment(millions) PresentValue(at6%)1 $899.00 $848.112 $846.00 $752.943 $738.00 $619.644 $598.00 $473.675 $477.00 $356.446&7 $982.50eachyear $1,346.04¨ DebtValueofleases= $4,396.85(Alsovalueofleasedasset)¨ DebtoutstandingatTheGap=$1,970m+$4,397m=$6,367m¨ AdjustedOperatingIncome=StatedOI+OLexp thisyear- Deprec’n
=$1,012m+978m- 4397m/7=$1,362million(7yearlifeforassets)¨ ApproximateOI=$1,012m+$4397m(.06)=$1,276m
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TheCollateralEffectsofTreatingOperatingLeasesasDebt
! Conventional!Accounting! Operating!Leases!Treated!as!Debt!Income!Statement!
EBIT&&Leases&=&1,990&0&Op&Leases&&&&&&=&&&&978&EBIT&&&&&&&&&&&&&&&&=&&1,012&
!Income!Statement!EBIT&&Leases&=&1,990&0&Deprecn:&OL=&&&&&&628&EBIT&&&&&&&&&&&&&&&&=&&1,362&
Interest&expense&will&rise&to&reflect&the&conversion&of&operating&leases&as&debt.&Net&income&should¬&change.&
Balance!Sheet!Off&balance&sheet&(Not&shown&as&debt&or&as&an&asset).&Only&the&conventional&debt&of&$1,970&million&shows&up&on&balance&sheet&&
Balance!Sheet!Asset&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&Liability&OL&Asset&&&&&&&4397&&&&&&&&&&&OL&Debt&&&&&4397&
Total&debt&=&4397&+&1970&=&$6,367&million&
Cost&of&capital&=&8.20%(7350/9320)&+&4%&(1970/9320)&=&7.31%&
Cost&of&equity&for&The&Gap&=&8.20%&After0tax&cost&of&debt&=&4%&Market&value&of&equity&=&7350&
Cost&of&capital&=&8.20%(7350/13717)&+&4%&(6367/13717)&=&6.25%&&
Return&on&capital&=&1012&(10.35)/(3130+1970)&&&&&&&&&&=&12.90%&
Return&on&capital&=&1362&(10.35)/(3130+6367)&&&&&&&&&&=&9.30%&
&
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TheMagnitudeofR&DExpenses
R&D as % of Operating Income
0.00%
10.00%
20.00%
30.00%
40.00%
50.00%
60.00%
Market Petroleum Computers
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R&DExpenses:OperatingorCapitalExpenses
¨ AccountingstandardsrequireustoconsiderR&Dasanoperatingexpenseeventhoughitisdesignedtogeneratefuturegrowth.Itismorelogicaltotreatitascapitalexpenditures.
¨ TocapitalizeR&D,¤ SpecifyanamortizablelifeforR&D(2- 10years)¤ CollectpastR&Dexpensesforaslongastheamortizablelife¤ SumuptheunamortizedR&Dovertheperiod.(Thus,iftheamortizablelifeis5years,theresearchassetcanbeobtainedbyaddingup1/5thoftheR&Dexpensefromfiveyearsago,2/5thoftheR&Dexpensefromfouryearsago...:
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CapitalizingR&DExpenses:SAP
¨ R&Dwasassumedtohavea5-yearlife.Year R&DExpense Unamortized AmortizationthisyearCurrent 1020.02 1.00 1020.02-1 993.99 0.80 795.19 €198.80-2 909.39 0.60 545.63 €181.88-3 898.25 0.40 359.30 €179.65-4 969.38 0.20 193.88 €193.88-5 744.67 0.00 0.00 €148.93Valueofresearchasset= €2,914millionAmortizationofresearchassetin2004 = €903millionIncreaseinOperatingIncome=1020- 903= €117million
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TheEffectofCapitalizingR&DatSAP
! Conventional!Accounting! R&D!treated!as!capital!expenditure!Income!Statement!
EBIT&&R&D&&&=&&3045&.&R&D&&&&&&&&&&&&&&=&&1020&EBIT&&&&&&&&&&&&&&&&=&&2025&EBIT&(1.t)&&&&&&&&=&&1285&m&
!Income!Statement!EBIT&&R&D&=&&&3045&.&Amort:&R&D&=&&&903&EBIT&&&&&&&&&&&&&&&&=&2142&(Increase&of&117&m)&EBIT&(1.t)&&&&&&&&=&1359&m&
Ignored&tax&benefit&=&(1020.903)(.3654)&=&43&Adjusted&EBIT&(1.t)&=&1359+43&=&1402&m&(Increase&of&117&million)&Net&Income&will&also&increase&by&117&million&&
Balance!Sheet!Off&balance&sheet&asset.&Book&value&of&equity&at&3,768&million&Euros&is&understated&because&biggest&asset&is&off&the&books.&
Balance!Sheet!Asset&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&Liability&R&D&Asset&&&&2914&&&&&Book&Equity&&&+2914&
Total&Book&Equity&=&3768+2914=&6782&mil&&Capital!Expenditures!
Conventional&net&cap&ex&of&2&million&Euros&
Capital!Expenditures!Net&Cap&ex&=&2+&1020&–&903&=&119&mil&
Cash!Flows!EBIT&(1.t)&&&&&&&&&&=&&1285&&.&Net&Cap&Ex&&&&&&=&&&&&&&&2&FCFF&&&&&&&&&&&&&&&&&&=&&1283&&&&&&
Cash!Flows!EBIT&(1.t)&&&&&&&&&&=&&&&&1402&&&.&Net&Cap&Ex&&&&&&=&&&&&&&119&FCFF&&&&&&&&&&&&&&&&&&=&&&&&1283&m&
Return&on&capital&=&1285/(3768+530)& Return&on&capital&=&1402/(6782+530)&
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III.One-TimeandNon-recurringCharges
¨ Assumethatyouarevaluingafirmthatisreportingalossof$500million,duetoaone-timechargeof$1billion.Whatistheearningsyouwoulduseinyourvaluation?a. Alossof$500millionb. Aprofitof$500million
¨ Wouldyouranswerbeanydifferentifthefirmhadreportedone-timelossesliketheseonceeveryfiveyears?a. Yesb. No
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IV.AccountingMalfeasance….
¨ Thoughallfirmsmaybegovernedbythesameaccountingstandards,thefidelitythattheyshowtothesestandardscanvary.Moreaggressivefirmswillshowhigherearningsthanmoreconservativefirms.
¨ Whileyouwillnotbeabletocatchoutrightfraud,youshouldlookforwarningsignalsinfinancialstatementsandcorrectforthem:¤ Incomefromunspecifiedsources- holdingsinotherbusinessesthatare
notrevealedorfromspecialpurposeentities.¤ Incomefromassetsalesorfinancialtransactions(foranon-financialfirm)¤ Suddenchangesinstandardexpenseitems- abigdropinS,G&AorR&D
expensesasapercentofrevenues,forinstance.¤ Frequentaccountingrestatements¤ Accrualearningsthatrunaheadofcashearningsconsistently¤ Bigdifferencesbetweentaxincomeandreportedincome
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V.DealingwithNegativeorAbnormallyLowEarnings
A Framework for Analyzing Companies with Negative or Abnormally Low Earnings
Why are the earnings negative or abnormally low?
TemporaryProblems
Cyclicality:Eg. Auto firmin recession
Life Cycle related reasons: Young firms and firms with infrastructure problems
LeverageProblems: Eg. An otherwise healthy firm with too much debt.
Long-termOperatingProblems: Eg. A firm with significant production or cost problems.
Normalize Earnings
Value the firm by doing detailed cash flow forecasts starting with revenues and reduce or eliminate the problem over time.:(a) If problem is structural: Target for operating margins of stable firms in the sector.(b) If problem is leverage: Target for a debt ratio that the firm will be comfortable with by end of period, which could be its own optimal or the industry average.(c) If problem is operating: Target for an industry-average operating margin.
If firmʼs size has notchanged significantlyover time
Average DollarEarnings (Net Income if Equity and EBIT if Firm made bythe firm over time
If firmʼs size has changedover time
Use firmʼs average ROE (if valuing equity) or average ROC (if valuing firm) on current BV of equity (if ROE) or current BV of capital (if ROC)
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Whattaxrate?
¨ Thetaxratethatyoushoulduseincomputingtheafter-taxoperatingincomeshouldbea. Theeffectivetaxrateinthefinancialstatements(taxes
paid/Taxableincome)b. ThetaxratebasedupontaxespaidandEBIT(taxespaid/EBIT)c. Themarginaltaxrateforthecountryinwhichthecompany
operatesd. Theweightedaveragemarginaltaxrateacrossthecountriesin
whichthecompanyoperatese. Noneoftheabovef. Anyoftheabove,aslongasyoucomputeyourafter-taxcostof
debtusingthesametaxrate
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TheRightTaxRatetoUse
¨ Thechoicereallyisbetweentheeffectiveandthemarginaltaxrate.Indoingprojections,itisfarsafertousethemarginaltaxratesincetheeffectivetaxrateisreallyareflectionofthedifferencebetweentheaccountingandthetaxbooks.
¨ Byusingthemarginaltaxrate,wetendtounderstatetheafter-taxoperatingincomeintheearlieryears,buttheafter-taxtaxoperatingincomeismoreaccurateinlateryears
¨ Ifyouchoosetousetheeffectivetaxrate,adjustthetaxratetowardsthemarginaltaxrateovertime.¤ Whileanargumentcanbemadeforusingaweightedaverage
marginaltaxrate,itissafesttousethemarginaltaxrateofthecountry
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ATaxRateforaMoneyLosingFirm
¨ Assumethatyouaretryingtoestimatetheafter-taxoperatingincomeforafirmwith$1billioninnetoperatinglossescarriedforward.Thisfirmisexpectedtohaveoperatingincomeof$500millioneachyearforthenext3years,andthemarginaltaxrateonincomeforallfirmsthatmakemoneyis40%.Estimatetheafter-taxoperatingincomeeachyearforthenext3years.
Year1 Year2 Year3EBIT 500 500 500TaxesEBIT(1-t)Taxrate
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NetCapitalExpenditures
¨ Netcapitalexpendituresrepresentthedifferencebetweencapitalexpendituresanddepreciation.Depreciationisacashinflowthatpaysforsomeoralot(orsometimesallof)thecapitalexpenditures.
¨ Ingeneral,thenetcapitalexpenditureswillbeafunctionofhowfastafirmisgrowingorexpectingtogrow.Highgrowthfirmswillhavemuchhighernetcapitalexpendituresthanlowgrowthfirms.
¨ Assumptionsaboutnetcapitalexpenditurescanthereforeneverbemadeindependentlyofassumptionsaboutgrowthinthefuture.
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Capitalexpendituresshouldinclude
¨ Researchanddevelopmentexpenses,oncetheyhavebeenre-categorizedascapitalexpenses.Theadjustednetcapexwillbe¤ AdjustedNetCapitalExpenditures=NetCapitalExpenditures+
Currentyear’sR&Dexpenses- AmortizationofResearchAsset¨ Acquisitionsofotherfirms,sincethesearelikecapital
expenditures.Theadjustednetcapexwillbe¤ AdjustedNetCapEx=NetCapitalExpenditures+Acquisitionsofother
firms- Amortizationofsuchacquisitions¨ Twocaveats:
1.Mostfirmsdonotdoacquisitionseveryyear.Hence,anormalizedmeasureofacquisitions(lookingatanaverageovertime)shouldbeused
2.Thebestplacetofindacquisitionsisinthestatementofcashflows,usuallycategorizedunderotherinvestmentactivities
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Cisco’sAcquisitions:1999
Acquired MethodofAcquisition PricePaidGeoTel Pooling $1,344Fibex Pooling $318Sentient Pooling $103AmericanInternet Purchase $58SummaFour Purchase $129ClarityWireless Purchase $153Selsius Systems Purchase $134PipeLinks Purchase $118Amteva Tech Purchase $159
$2,516
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Cisco’sNetCapitalExpendituresin1999
CapExpenditures(fromstatementofCF)=$584mil- Depreciation(fromstatementofCF) =$486milNetCapEx(fromstatementofCF)=$98mil+R&Dexpense =$1,594mil- AmortizationofR&D =$485mil+Acquisitions =$2,516milAdjustedNetCapitalExpenditures =$3,723mil
¨ (Amortizationwasincludedinthedepreciationnumber)
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WorkingCapitalInvestments
¨ Inaccountingterms,theworkingcapitalisthedifferencebetweencurrentassets(inventory,cashandaccountsreceivable)andcurrentliabilities(accountspayables,shorttermdebtanddebtduewithinthenextyear)
¨ Acleanerdefinitionofworkingcapitalfromacashflowperspectiveisthedifferencebetweennon-cashcurrentassets(inventoryandaccountsreceivable)andnon-debtcurrentliabilities(accountspayable)
¨ Forfirmsinsomesectors,itistheinvestmentinworkingcapitalthatisthebiggerpartofreinvestment.
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WorkingCapital:GeneralPropositions
1. Working Capital Detail: While some analysts break downworking capital into detail (inventory, deferred taxes,payables etc.), it is a pointless exercise unless you feel thatyou can bring some specific information that lets youforecast the details.
2. Working Capital Volatility: Changes in non-cash workingcapital from year to year tend to be volatile. So, building ofthe change in the most recent year is dangerous. It is betterto either estimate the change based on working capital as apercent of sales, while keeping an eye on industry averages.
3. Negative Working Capital: Some firms have negative non-cash working capital. Assuming that this will continue intothe future will generate positive cash flows for the firm andwill get more positive as growth increases.
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VolatileWorkingCapital?
Amazon Cisco MotorolaRevenues $1,640 $12,154 $30,931Non-cashWC -$419 -$404 $2547%ofRevenues -25.53% -3.32% 8.23%Changefromlastyear $(309) ($700) ($829)Average:last3years -15.16% -3.16% 8.91%Average:industry 8.71% -2.71% 7.04%
MyPredictionWCas%ofRevenue 3.00% 0.00% 8.23%
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DividendsandCashFlowstoEquity
¨ Inthestrictestsense,theonlycashflowthataninvestorwillreceivefromanequityinvestmentinapubliclytradedfirmisthedividendthatwillbepaidonthestock.
¨ Actualdividends,however,aresetbythemanagersofthefirmandmaybemuchlowerthanthepotentialdividends(thatcouldhavebeenpaidout)¤ managersareconservativeandtrytosmoothoutdividends¤ managersliketoholdontocashtomeetunforeseenfuturecontingenciesandinvestmentopportunities
¨ Whenactualdividendsarelessthanpotentialdividends,usingamodelthatfocusesonlyondividendswillunderstatethetruevalueoftheequityinafirm.
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MeasuringPotentialDividends
¨ Someanalystsassumethattheearningsofafirmrepresentitspotentialdividends.Thiscannotbetrueforseveralreasons:¤ Earningsarenotcashflows,sincetherearebothnon-cashrevenuesand
expensesintheearningscalculation¤ Evenifearningswerecashflows,afirmthatpaiditsearningsoutas
dividendswouldnotbeinvestinginnewassetsandthuscouldnotgrow¤ Valuationmodels,whereearningsarediscountedbacktothepresent,will
overestimatethevalueoftheequityinthefirm¨ Thepotentialdividendsofafirmarethecashflowsleftoverafter
thefirmhasmadeany“investments” itneedstomaketocreatefuturegrowthandnetdebtrepayments(debtrepayments- newdebtissues)¤ Thecommoncategorizationofcapitalexpendituresintodiscretionaryand
non-discretionarylosesitsbasiswhenthereisfuturegrowthbuiltintothevaluation.
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EstimatingCashFlows:FCFE
¨ CashflowstoEquityforaLeveredFirmNetIncome- (CapitalExpenditures- Depreciation)- Changesinnon-cashWorkingCapital- (PrincipalRepayments- NewDebtIssues)=FreeCashflowtoEquity
¨ Ihaveignoredpreferreddividends.Ifpreferredstockexist,preferreddividendswillalsoneedtobenettedout
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EstimatingFCFEwhenLeverageisStable
NetIncome- (1- DR)(CapitalExpenditures- Depreciation)- (1- DR)WorkingCapitalNeeds=FreeCashflowtoEquity
DR=Debt/CapitalRatioForthisfirm,
¤ Proceedsfromnewdebtissues=PrincipalRepayments+d(CapitalExpenditures- Depreciation+WorkingCapitalNeeds)
¨IncomputingFCFE,thebookvaluedebttocapitalratioshouldbeusedwhenlookingbackintimebutcanbereplacedwiththemarketvaluedebttocapitalratio,lookingforward.
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EstimatingFCFE:Disney
¨ NetIncome=$1533Million¨ Capitalspending=$1,746Million¨ DepreciationperShare=$1,134Million¨ Increaseinnon-cashworkingcapital=$477Million¨ DebttoCapitalRatio(DR)=23.83%¨ EstimatingFCFE(1997):
NetIncome $1,533Mil- (Cap.Exp - Depr)*(1-DR) $465.90[(1746-1134)(1-.2383)]Chg.WorkingCapital*(1-DR) $363.33 [477(1-.2383)]=FreeCFtoEquity $704Million
DividendsPaid $345Million
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FCFEandLeverage:Isthisafreelunch?
Debt Ratio and FCFE: Disney
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0% 10% 20% 30% 40% 50% 60% 70% 80% 90%
Debt Ratio
FCFE
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FCFEandLeverage:TheOtherShoeDrops
Debt Ratio and Beta
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0% 10% 20% 30% 40% 50% 60% 70% 80% 90%Debt Ratio
Beta
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Leverage,FCFEandValue
¨ Inadiscountedcashflowmodel,increasingthedebt/equityratiowillgenerallyincreasetheexpectedfreecashflowstoequityinvestorsoverfuturetimeperiodsandalsothecostofequityappliedindiscountingthesecashflows.Whichofthefollowingstatementsrelatingleveragetovaluewouldyousubscribeto?a. Increasingleveragewillincreasevaluebecausethecashfloweffects
willdominatethediscountrateeffectsb. Increasingleveragewilldecreasevaluebecausetheriskeffectwillbe
greaterthanthecashfloweffectsc. Increasingleveragewillnotaffectvaluebecausetheriskeffectwill
exactlyoffsetthecashfloweffectd. Anyoftheabove,dependinguponwhatcompanyyouarelookingat
andwhereitisintermsofcurrentleverage
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