Cash Flow And Leverage(12-13)

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Cash Flow And Leverage(12-13)

• Professor Trainor

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Video Nickel

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Cash Flow Versus Accounting Profit
Capital budgeting concerned with cash flow, not
accounting profit.
The timing and magnitude of cash flows and
accounting profits can differ dramatically.
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Cash Flow and Non-Tax Expenses

• Accountants charge depreciation to spread a fixed
  assets costs over time to match its benefits.
• Capital budgeting analysis focuses on cash
  inflows and outflows when they occur.
• 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.

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Two Methods of Handling Depreciation to Compute
Cash Flow
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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 investments tax
  benefits.
• Relative to MACRS, straight-line depreciation
  results in higher reported earnings early in an
  investments life.

For capital budgeting analysis, the depreciation
method for tax purposes matters most.
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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)

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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.

• An example
• 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

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Working Capital for Calendar Sales Booth
0
0
3,000
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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.

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Terminal Value
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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)

• Terminal value is 68.2 billion value of entire
  project is

• 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

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Incremental Cash Flow
Incremental cash flows versus sunk costs
Capital budgeting analysis should include only
incremental costs.
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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 have increased to 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
• MBA has substantial positive NPV value if 30 yr
  analysis period

What about Norms opportunity cost?
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Video Rajan

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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
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Operating Leverage
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Operating Leverage
Degree of Operating Leverage

• The degree of operating leverage (DOL) measures
  the sensitivity of changes in EBIT to changes in
  Sales.
• A companys 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.

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Operating Leverage
Degree of Operating Leverage
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Operating Leverage
Degree of Operating Leverage
Interval Estimate of DOL
DOL Change in EBIT 35 3.50
Change in Sales 10
Because of the presence of fixed costs in the
firms 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.
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Financial Leverage

• Financial leverage results from the presence of
  fixed financial costs in the firms 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
  firms EPS.
• The two fixed financial costs most commonly found
  on the firms income statement are (1) interest
  on debt and (2) preferred stock dividends.

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Financial Leverage
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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.

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Financial Leverage
Degree of Financial Leverage
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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.
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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 firms earnings per share.
• Total leverage can therefore be viewed as the
  total impact of the fixed costs in the firms
  operating and financial structure.

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Total Leverage
Degree of Total Leverage
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Total Leverage
Degree of Total Leverage
Interval Estimate of DTL
DTL Change in EPS 46.7
4.67 Change in Sales 10
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.
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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.
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Carbonlite Inc. vs. Fiberspeed Corp.
The two firms are in the same industry.
Carbonlite Inc Fiberspeed Corp
Sales volume 10,000 sofas 10,000 sofas
Price 1,000 1,000
Total Revenue 10,000,000 10,000,000
Fixed costs per year 5,000,000 2,000,000
Variable costs per frame 400 700
Total cost 9,000,000 9,000,000
EBIT 1,000,000 1,000,000
What if sales volume increases by 10 ?
Carbonlites EBIT increases faster because it has
high operating leverage.
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Operating Leverage for Carbonlite and Fiberspeed
?EBIT
Carbonlite
 
Fiberspeed
?Sales
Other things equal, higher operating leverage
means that Carbonlites beta will be higher than
Fiberspeeds beta.
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The Effect of Financial Lev. On Beta
Firm 1 Firm 2
Assets 100 million 100 million
Debt 0 50 million
Equity 100 million 50 million
Case 1 Gross Return on Assets Equals 20 Percent Case 1 Gross Return on Assets Equals 20 Percent Case 1 Gross Return on Assets Equals 20 Percent
EBIT 20 million 20 million
Interest 0 4 million
Cash to equity 20 million 16 million
ROE 20 100 20 16 50 32
Case 2 Gross Return on Assets Equals 5 Percent Case 2 Gross Return on Assets Equals 5 Percent Case 2 Gross Return on Assets Equals 5 Percent
EBIT 5 million 5 million
Interest 0 4 million
Cash to equity 5 million 1 million
ROE 5 100 5 1 50 2
Financial leverage makes Firm 2s ROE more
volatile, so its beta will be higher .
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