Cash Accounting, Accrual Accounting, and Discounted Cash Flow Analysis

1
Cash Accounting, Accrual Accounting, and
Discounted Cash Flow Analysis
Chapter 4
2
Cashing Accounting, Accrual Accounting, and
Discounted Cash Flow Analysis
Chapter 3 outlined the process of fundamental
analysis and depicted valuation as a matter of
forecasting future financial statements
Link to pervious chapter
This chapter introduces discounted cash flow
valuation, a method that involves forecasting
future cash flow statements. The chapter also
shows how cash flows differ from accrual earnings
in the income statement, and how ignoring
accruals in discounted cash flow valuation can
cause problems.
This Chapter
What form of accounting best captures value added
in operations cash accounting or accrual
accounting?
What is the difference between cash accounting
and accrual accounting?
How does one derive free cash flow from the
statement of cash flows?
What is the discounted cash flow model? Does it
work?
Chapter 5 and 6 together lay out valuation
methods that forecast accrual accounting income
statements and balance sheets.
Link to next chapter
This web page provides further explanation and
additional examples of discounted cash flow
analysis, cash accounting, and accrual accounting.
Link to web page
3
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

4
Cash Flows for a Going Concern
Free cash flow is cash flow from operations that
results from investments minus cash used to make
investments.
5
The Discounted Cash Flow Model (DCFM)
6
The Continuing Value for the DCFM

• A. Capitalize terminal free cash flow
• B. Capitalize terminal free cash flow with growth
• Will it work?

7
DCF Valuation New York State Electric and Gas
8
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

9
The DCFM Will it work for Wal-Mart Stores?
10
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

11
Discounted Cash Flow Analysis Advantages and
Disadvantages
12
Statement of Cash Flows Dell Computer
13
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

14
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

15
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 Cas
h 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. Dells
statutory tax rate (for federal and state taxes)
is 35 percent, as indicated in the
financial Statement footnotes.
16
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
• (i) Forecast earnings available to common
• (ii) Forecast accruals (the difference between
  earnings and cash flow from operations in the
  cash flow statement)
• (iii) Calculate levered cash flow from operations
  (Step (i) -
• Step (ii))
• (iv) Calculate unlevered cash flow from
  operations by adding after-tax net interest
• (v) Forecast cash investments in operations
• (vi) Calculate forecasted free cash flow, C - I
  (Step (iv) -
• Step (v))

17
Forecasting Free Cash Flow Dell Computer
18
Features of the Income Statement

• 1. Dividends dont affect income
• 2. Investment doesnt affect income
• 3. There is a matching of
• Value added (revenues)
• Value lost (expenses)
• Net value added (net income)
• 4. Accruals adjust cash flows

Revenue Accruals
Value added that is not cash flow
Adjustments to cash inflows that are not value
added
Expense Accruals
Value decreases that are not cash flows
Adjustments to cash outflows that are not value
decreases
19
The Income Statement Dell Computer
20
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

21
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

22
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.

23
Earnings and Cash Flows Wal-Mart Stores
24
Accruals, Investments and the Balance Sheet

• Accruals and investments are put in the balance
  sheet

Shareholders equity Cash Other Assets -
Liabilities
Cash from Operations
Accruals
Free cash flow
Cash from Operations
Investments
25
The Balance Sheet Dell Computer
26
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