Professional Documents
Culture Documents
Enterprise Finance Lectures
Enterprise Finance Lectures
ENTERPRISE FINANCE
LECTURES
VALUE PAGES 22 – 36
ROIC PAGES 37 – 58
1
Lectures 1 - 10
2
Lectures 1 - 10
VALUE
3
Lectures 1 - 10
ROIC
4
Lectures 1 - 10
CREDIT HEALTH
5
£m t0 t1
Cash flow -9.1 10
Net cash flow 0.9
£m t0 t1
Cash flow -9.1 10
Discount at 3% * 1/1.03
Present value (Cash flow) -9.1 9.7
Net present value (Cash
0.6
flow) NPV
£m t0 t1
Cash flow -9.1 10
Discount at 10% * 1/1.10
Present value (Cash flow) -9.1 9.1
Net present value (Cash
0.0
flow) NPV
t0 t1
Cash flow -3.3 5.5
Discount at 15% * 1/1.15
Present value (Cash flow) -3.3 4.8
Net present value (Cash
1.5
flow) NPV
t0 t1
Sales 5.5
Depreciation -3.3
Accounting profit (AP) 2.2
less Capital charge
3.3 * 15% -0.5
Economic profit (EP) 1.7
Discount at 15% * 1/ 1.15
PV(EP) 1.5
Row
ISt1 $m BSt1 BSt0 BS incrementt1 CFSt1
number
1 Sales 100.0 Debtors 0 0 0 Customers 100.0 NOPAT 8.3
2 Stock 0 0 0 add back:
3 Expenses -81.7 Creditors 0 0 0 Suppliers -81.7 Tax expense 0
4 EBITDA 18.3 WC 0 0 0 CFO 18.3 EBIT 8.3
5 Depreciation -10.0 FA 58.9 55.6 3.3 CAPEX -13.3 add back:
6 EBIT 8.3 Depreciation 10.0
7 Tax expense 0 Tax creditor 0 0 0 Tax paid 0 EBITDA 18.3
8 Cash 0 0 0 Cash increase 0 less:
9 EBI or NOPAT 1 8.3 IC increment1 58.9 55.6 3.3 FCF1 5.0 WC increment 0
NOPAT 1 8.3
Interest
0
expense
Earnings 8.3
Dividend -5.0
Retained -3.3
Finance loss -8.3
Row
ISt1 $m BSt1 BSt0 BS incrementt1 CFSt1
number
1 Sales 80.60 Debtors 8.86 6.29 2.57 Customers 78.03
2 Stock 0.44 0.31 0.13
3 Expenses -13.01 Creditors -21.48 -15.23 -6.25 Suppliers -6.89
4 EBITDA 67.59 WC -12.18 -8.63 -3.55 CFO 71.14
5 Depreciation -7.33 FA 226.95 226.95 0.00 CAPEX -7.33
6 EBIT 60.26
7 Tax expense -18.08 Tax creditor -0.60 -0.45 -0.15 Tax paid -17.93
8 Cash 71.86 50.97 20.89 Cash increase -20.89
10 Interest -0.50 Interest creditor 0.00 0.00 0.00 Interest paid -0.50
11 Debt -2.76 -2.59 -0.17 Debt issue 0.17
12 Dividend -24.65 Dividend creditor 0.00 0.00 0.00 Dividend paid -24.65
13 Equity shares -23.48 -23.48 0.00 Equity issue 0.00
14 Retained -17.03 Equity reserves -259.79 -242.76 -17.03
Financial Finance cash
15 Finance loss1 -42.18 -286.03 -268.84 -17.19 -24.99
capital1 flow 1
IS Income Statement BS Balance Sheet CFS Cash Flow Statement
EBITDA Earnings Before Interest Tax Depreciation and Amortisation IC Invested Capital
NOPAT Net Operating Profit CFO Cash From Operating
WC Working Capital CAPEX Capital Expenditure
FA Fixed Asset FCF Free Cash Flow
Debtors
01-Jan b/f 0
31-Jan c/f 0
t0 t1 t2 t3 t4 t5 t6 to perpetuity
Free cash
5.0 5.5 6.1 6.7 7.3 8.1
flow FCF
Discount
15% 1/(1.15) 1/(1.15)2 1/(1.15)3 1/(1.15)4 1/(1.15)5 1/(1.15)5
at
1/(0.15 - 0.10)
PV(FCF) 100.0 4.3 4.2 4.0 3.8 3.6 80.1
t0 t1 t2 to perpetuity
Cash flownew opportunity 8.33 * 40% = - 3.33 3.33 * 25% = 0.83
Discount 15% 1/0.15
PV(CF) -3.33 5.55
t1 to perpetuity
NPV 2.22
growing at 10%
Discount 15% 1/(0.15 -0.10)
PV(NPV) or Goodwill 44.4
Book 55.6
Value 100.0
t0 t1 to perpetuity
Dividend 5.0
growing at 10%
Discount at 15% 1/(1.15 - 0.10)
PV(Dividend) 100.0 100.0
Debt 0
Value 100.0
t0 t1 to perpetuity
Earnings 8.33
Discount at yield 8.33% 1/0.0833
PV(Dividend) 100.0 100.0
Debt 0
Value 100.0
t0 t1 to perpetuity
Earnings 8.33
growing at 6.7%
Discount at 15.00% 1/(0.15 - 0.067)
PV(Dividend) 100.0 100.0
Debt 0
Value 100.0
Lectures 1 - 3
Table 1
Row IS ISt1 BS BSt1 BSt0 BS CFS CFSt1
number
incrementt1
1 Sales 100.0 Debtors 0 0 0 Customers 100.0
2 Stock 0 0 0
INVESTING
You can use this primary statement matrix to reconcile any accounting number to any other
accounting number and to cash flows. Accounting numbers and cash numbers are used more
intelligently when their relationships are made explicit, as they are in this matrix.
The investing story is told in the top half of the matrix and runs as follows. You make a profit
of £8.3, of which you invest £3.3, delivering a free cash flow of £5.
The financing story is told in the bottom half of the statement and runs as follows. You make a
profit of £8.3 of which you distribute £ 5 and retain £3.3. You invest £3.3, which you finance
with equity reserves increment. You deliver a free cash flow of £5, which is wholly paid out as
dividend.
Here we concentrate on two relations. The first is the relation between the three statements
(the clean surplus relation), illustrated by each row, and the second is the relation between the
top half and the bottom half (the investing-to-financing relation), illustrated by each column.
Note that the bottom line of the income statement is labelled net operating profit after tax
NOPAT, which is a more precise name than simply accounting profit AP.
1
Lectures 1 - 3
In order to build this matrix we reorder the statements from their published order. The clean
surplus relation and the investing-to-financing relation dictate a certain ordering and that is the
order we have adopted.
We now describe each row in turn beginning with the investing rows and row 1.
Row BS
number
IS ISt1 BS BSt1 BSt0 CFS CFSt1
incrementt1
1 Sales 100.0 Debtors 0 0 0 Customers 100.0
row1 Sales £100 less Debtors increment £0 = Cash from customers £100
P&L sales equal CFS cash from customers because there is no change in the BS debtors.
Increase the debtors by £100 then £0 cash is collected from the customers. This cash is held up
in debtors, awaiting collection. None of the customers pay.
Row BS
number
IS ISt1 BS BSt1 BSt0 CFS CFSt1
incrementt1
1 Sales 100.0 Debtors 100.0 0 100.0 Customers 0
2
Lectures 1 - 3
Table 3
BS Creditors
01-Jan BS b/f 0
CFS Suppliers 81.7 BS Stock 81.7
31-Jan BS c/f 0
81.7 81.7
Table 4
BS Stock
01-Jan BS b/f 0
BS Creditors 81.7 IS Expenses 81.7
31-Jan BS c/f 0
81.7 81.7
Increase the creditors by £81.7 then £0 cash is paid to the suppliers. This cash is held up in
creditors, awaiting payment. None of the suppliers are paid.
Row BS
number IS ISt1 BS BSt1 BSt0 CFS CFSt1
incrementt1
2 Stock 0 0 0
3 Expenses -81.7 Creditors -81.7 0 -81.7 Suppliers 0
Cash flow from operating is an interesting subtotal being the net cash inflow of cash collected
from customers less cash paid to suppliers. From the above relation we can see that EBITDA
(an IS number) can be used as a proxy for CFO (a CFS number) if the working capital
incremental investment (or disinvestment) is £0.
Increase the working capital by say £11 then CFO falls to £7.3. The proxy relation breaks
down.
Row BS
number IS ISt1 BS BSt1 BSt0 CFS CFSt1
incrementt1
4 EBITDA 18.3 WC 11.0 0 11.0 CFO 7.3
3
Lectures 1 - 3
We can see that the cash outflow of £13.3 on fixed assets consists of spending to replace assets
used up during the year of £10, plus spending to grow of £3.3.
Leave the fixed assets unchanged and the CAPEX falls to £10, now all replacement spending,
with no growth.
Row BS
number IS ISt1 BS BSt1 BSt0 CFS CFSt1
incrementt1
5 Depreciation -10.0 FA 55.6 55.6 0 CAPEX -10.0
Row 6 simply calculates an IS subtotal being EBIT, which follows EBITDA and precedes
EBI.
We can see that the tax expense (IS number) is only the same as the tax paid (CFS number) if
there is no change to the tax creditor in the BS.
4
Lectures 1 - 3
This row is very important. It totals all the investing rows 1 – 8. It defines free cash flow as:
FCF = NOPAT – IC increment
With no incremental investment in the balance sheet, that is the manager fails to find a
positive NPV opportunity, then NOPAT equals FCF.
Row BS
number IS ISt1 BS BSt1 BSt0 CFS CFSt1
incrementt1
EBI or IC
9 8.3 55.6 55.6 0 FCF1 8.3
NOPAT1 increment1
With incremental investment in the balance sheet greater than NOPAT, then FCF is negative.
Row BS
number IS ISt1 BS BSt1 BSt0 CFS CFSt1
incrementt1
EBI or IC
9 8.3 75.6 55.6 20 FCF1 -11.7
NOPAT1 increment1
Table 6
BS Interest creditor
01-Jan BS b/f 0
CFS Interest paid 0 IS Interest expense 0
31-Jan BS c/f 0
0 0
There is a small point to note about the position of the interest expense. The published IS
account positions the interest expense before the tax expense but the matrix moves it further
down to after tax and after NOPAT. The published IS recognises that interest is a tax
deductible expense, hence positions it before the tax expense. The matrix recognises that
interest is a financing expense rather than an investing expense so positions it with financing.
This means that the published IS’s PAT is also after interest while the matrix’s NOPAT is
before interest.
5
Lectures 1 - 3
Table 7
BS Debt
01-Jan BS b/f 0
CFS Issue 0
31-Jan BS c/f 0
0 0
Increase the BS debt £11.7, then the CFS shows £11.7 as issued. This issue could finance the
negative free cash flow in the previous scenario.
Row BS
number IS ISt1 BS BSt1 BSt0 CFS CFSt1
incrementt1
11 Debt -11.7 0 -11.7 Debt issue 11.7
Table 8
BS Dividend creditor
01-Jan BS b/f 0
CFS Dividend paid 5 IS Dividend expense 5
31-Jan BS c/f 0
5 5
6
Lectures 1 - 3
Table 9
BS Equity shares
01-Jan BS b/f 50
CFS Issue 0
31-Jan BS c/f 50
50 50
Increase the BS equity shares £11.7, then the CFS shows £11.7 as issued. This issue could
finance the negative free cash flow in the previous scenario.
Row BS
number IS ISt1 BS BSt1 BSt0 CFS CFSt1
incrementt1
Equity Equity share
13 -61.7 50 -11.7 11.7
shares issue
Table 10
BS Equity reserves
01-Jan BS b/f 5.6
IS Retained 3.3
31-Jan BS c/f 8.9
8.9 8.9
We can see that the equity reserves increment (BS) is wholly explained by the retained profit
(P&L) and this is always the case so there is never a CFS number generated.
7
Lectures 1 - 3
This completes the analysis of the clean surplus relation row by row. We now look at the
second relation, the investing-to-financing relation, column by column.
8
Lectures 1 - 3
Investing = -Financing
Sales 100.0
Expenses -81.7
EBITDA 18.3
Depreciation -10.0
EBIT 8.3
Tax expense 0
EBI or NOPAT1 8.3
Interest expense 0
Dividend -5.0
Retained -3.3
Finance loss1 -8.3
column 1 IS Net Operating Profit After Tax £8.3 from investing = - P&L Finance loss £8.3
from financing.
You earn a profit of £8.3. The financing section explains what you do with it. You use it for
interest £0, for dividend £5.0, and you reinvest in the company £3.3.
You invest an incremental £3.3 so that invested capital grows by £3.3. This incremental
investment is wholly financed by an increase in equity reserve of £3.3.
9
Lectures 1 - 3
Customers 100.0
Suppliers -81.7
CFO 18.3
CAPEX -13.3
Tax paid 0
Cash increase 0
FCF1 5.0
Interest paid 0
Debt issue 0
Dividend paid -5.0
Equity issue 0
Finance cash flow1 -5.0
column 3 CFS Free Cash Flow £5.0 = - CFS Dividend paid £5.0
You have a net cash inflow for the year of £5.0, which is described as free because it is free to
be paid out in interest and dividend or to repurchase debt or equity. In this case the free cash
flow is all paid out as dividend.
10
Lectures 1 - 3
You can use this matrix to reconcile any accounting number to any other accounting number.
The accounting numbers are those numbers in the P&L and in the balance sheet. You can also
reconcile any accounting number to any cash number (in the cash flow statement).
Reconciliation 1
Row BS
IS ISt1 BS BSt1 BSt0 CFS CFSt1
number incrementt1
1 Sales 100.0 Debtors 0 0 0 Customers 100.0
2 Stock 0 0 0
3 Expenses -81.7 Creditors 0 0 0 Suppliers -81.7
4 EBITDA 18.3 WC 0 0 0 CFO 18.3
5 Depreciation -10.0 FA 58.9 55.6 3.3 CAPEX -13.3
6 EBIT 8.3
7 Tax expense 0 Tax creditor 0 0 0 Tax paid 0
8 Cash 0 0 0 Cash increase 0
9 EBI or NOPAT1 8.3 IC increment1 58.9 55.6 3.3 FCF1 5.0
10 Interest expense 0 Interest creditor 0 0 0 Interest paid 0
11 Debt 0 0 0 Debt issue 0
12 Dividend -5.0 Dividend creditor 0 0 0 Dividend paid -5.0
13 Equity shares -50.0 -50.0 0 Equity issue 0
14 Retained -3.3 Equity reserves -8.9 -5.6 -3.3
15 Finance loss1 -8.3 Financial capital1 -58.9 -55.6 -3.3 Finance cash flow1 -5.0
Table 11
NOPAT 8.3
add back:
Tax expense 0
EBIT 8.3
add back:
Depreciation expense 10.0
EBITDA 18.3
less:
WC increment 0
CFO 18.3
CAPEX -13.3
Tax paid 0
Cash increase 0
FCF 5.0
This reconciliation starts with IS NOPAT, works its way back up the IS to EBIT, then swings
across the BS change in WC to hit the cash flow statement CFS at cash from operating CFO,
and works its way down the CFS to finish at free cash flow FCF.
11
Lectures 1 - 3
Reconciliation 2
Row BS
IS ISt1 BS BSt1 BSt0 CFS CFSt1
number incrementt1
1 Sales 100.0 Debtors 0 0 0 Customers 100.0
2 Stock 0 0 0
3 Expenses -81.7 Creditors 0 0 0 Suppliers -81.7
4 EBITDA 18.3 WC 0 0 0 CFO 18.3
5 Depreciation -10.0 FA 58.9 55.6 3.3 CAPEX -13.3
6 EBIT 8.3
7 Tax expense 0 Tax creditor 0 0 0 Tax paid 0
8 Cash 0 0 0 Cash increase 0
9 EBI or NOPAT1 8.3 IC increment1 58.9 55.6 3.3 FCF1 5.0
10 Interest expense 0 Interest creditor 0 0 0 Interest paid 0
11 Debt 0 0 0 Debt issue 0
12 Dividend -5.0 Dividend creditor 0 0 0 Dividend paid -5.0
13 Equity shares -50.0 -50.0 0 Equity issue 0
14 Retained -3.3 Equity reserves -8.9 -5.6 -3.3
15 Finance loss1 -8.3 Financial capital1 -58.9 -55.6 -3.3 Finance cash flow1 -5.0
Table 12
NOPAT 8.3
less:
Interest expense 0
Earnings 8.3
less:
Retained 3.3
Dividend 5
This reconciliation starts with profit and, staying within the IS, finishes with dividend, running
through earnings.
12
Lectures 1 - 3
Ratio 1
Retained profit can be expressed as a fraction of NOPAT as follows:
Investment rate1 = Retained1 / NOPAT1
In this example the investment rate is £3.31/£8.31 = 40%
Ratio 2
NOPAT can be expressed as a fraction of Invested capital as follows:
ROIC1 = NOPAT1 / IC0
In this example ROIC is £8.31/£55.60 = 15%
Where ROIC is Return on Invested Capital. Note that this ratio has other names, for example
Return on Net Assets RONA, Return on Capital Employed ROCE.
Think of invested capital as debt + equity then where NOPAT is expressed as a fraction of just
the equity component of invested capital, the return is Return on Equity ROE.
Table 13
Invested capital IC 55.6
Interest creditor 0
Debt Debt 0
Dividend creditor 0
Equity shares Equity -50.0
Equity reserves -5.6
Financial capital -55.6
In this example ROIC and ROE are both 15% because there is no debt.
13
Lectures 1 - 3
$m
incrementt1
Row
number
CFSt1
BSt1
BSt0
ISt1
BS
1 Sales 80.60 Debtors 8.86 6.29 Customers
2 Stock 0.44 0.31
3 Expenses -13.01 Creditors -21.48 -15.23 Suppliers
4 EBITDA WC CFO
5 Depreciation -7.33 FA 226.95 226.95 CAPEX
6 EBIT
7 Tax expense -18.08 Tax creditor -0.60 -0.45 Tax paid
8 Cash 71.86 50.97 Cash increase
9 EBI or NOPAT 1 IC increment1 FCF1
10 Interest expense -0.50 Interest creditor 0.00 0.00 Interest paid
11 Debt -2.76 -2.59 Debt issue
12 Dividend Dividend creditor 0.00 0.00 Dividend paid
13 Equity shares -23.48 -23.48 Equity issue
14 Retained -17.03 Equity reserves -259.8 -242.76
Finance cash
15 Finance loss1 Financial capital1
flow1
IS Income Statement BS Balance Sheet CFS Cash Flow Statement
EBITDA Earnings Before Interest Tax Depreciation and Amortisation IC Invested Capital
NOPAT Net Operating Profit CFO Cash From Operating
WC Working Capital CAPEX Capital Expenditure
FA Fixed Asset FCF Free Cash Flow
14
Lectures 1 - 3
Solution
Table 15
$m
incrementt1
Row
number
CFSt1
BSt1
BSt0
ISt1
BS
1 Sales 80.60 Debtors 8.86 6.29 2.57 Customers 78.03
2 Stock 0.44 0.31 0.13
3 Expenses -13.01 Creditors -21.48 -15.23 -6.25 Suppliers -6.89
4 EBITDA 67.59 WC -12.18 -8.63 -3.55 CFO 71.14
5 Depreciation -7.33 FA 226.95 226.95 0.00 CAPEX -7.33
6 EBIT 60.26
7 Tax expense -18.08 Tax creditor -0.60 -0.45 -0.15 Tax paid -17.93
8 Cash 71.86 50.97 20.89 Cash increase -20.89
9 EBI or NOPAT 1 42.18 IC increment1 286.03 268.84 17.19 FCF1 24.99
10 Interest expense -0.50 Interest creditor 0.00 0.00 0.00 Interest paid -0.50
11 Debt -2.76 -2.59 -0.17 Debt issue 0.17
12 Dividend -24.65 Dividend creditor 0.00 0.00 0.00 Dividend paid -24.65
13 Equity shares -23.48 -23.48 0.00 Equity issue 0.00
14 Retained -17.03 Equity reserves -259.8 -242.76 -17.03
Finance cash
15 Finance loss1 -42.18 Financial capital1 -286.03 -268.84 -17.19 -24.99
flow1
IS Income Statement BS Balance Sheet CFS Cash Flow Statement
EBITDA Earnings Before Interest Tax Depreciation and Amortisation IC Invested Capital
NOPAT Net Operating Profit CFO Cash From Operating
WC Working Capital CAPEX Capital Expenditure
FA Fixed Asset FCF Free Cash Flow
In this scenario, the company earned a profit of £9 but invested £31 so generating a negative
free cash flow of £22, which they financed with a debt issue. The debt issue also financed
interest and dividend payments. Was the investment of £31 a positive NPV opportunity?
Nearly half (£14 of £31) is an investment in Debtors. If the company collected its debtors and
refrained from paying a dividend they could have avoided (£14 + £6) £20 of the debt issue,
leaving only an issue of £11 to cover the CAPEX growth component.
15
Lectures 1 - 3
Table 16
incr
IS t1 BS t0 t1 t1 CFS t0 t1
1 Sales 5.5 Debtors 0 0 0 Customers 5.5
2 Stock
3 Expenses Creditors Suppliers
4 EBITDA WC CFO
5 Depreciation -3.3 FA 3.3 0 -3.3 CAPEX -3.3 0
6 EBIT
7 Tax expense Tax creditor Tax paid
8 Cash Cash increase
9 NOPAT 1 2.2 IC increment1 3.3 0 -3.3 FCF1 -3.3 5.5
Capital charge £3.3 * 15% 0.5 Discount 15% 1/1.15
Economic Profit EP1 1.7 PV(FCF) -3.3 4.8
Discount 15% 1/1.15 NPV0 1.5
PV(EP)0 1.5
We should take this investment opportunity since the NPV is positive at £1.5. The realisation
of this NPV is monitored by economic profit. The matrix shows us how to reconcile NPV 0 to
NOPAT1.
Table 17
NOPAT 1 2.2
less:
Capital charge £3.3 * 15% 0.5
Economic profit EP1 1.7
Discount 15% 1/1.15
PV(EP)0 = NPV0 1.5
The actual/historical turns out exactly as expected. The expected NPV0 was realised as
actual/historical EP1. Note that NOPAT overstates the NPV but that the PV(EP) hits the NPV.
We return to EP and its application to corporate governance in chapter 6. EP is sometimes
referred to as Residual Income (RI) or Economic Value Added (EVA).
and
NPV0 = PV(EP1 - t) = PV(NOPAT1 - t – Capital charge1 - t)
16
Lectures 1 - 3
and when:
2. Balance Sheet accounting
2.1 lease of FA
2.2 bonus issue
2.3 acquisition or disposal of an associate or subsidiary during the year
Table 18
BS BS
IS ISt1 SORIE1 BS BSt1 BSt0
incrt1
CFS CFSt1
Accounting1
1 Sales 100.0 Debtors 0 0 0 Customers 100.0
2 Stock 0 0 0
3 Expenses -81.7 Creditors 0 0 0 Suppliers -81.7
4 EBITDA 18.3 WC 0 0 0 CFO 18.3
5 Depreciation -10.0 FA 58.9 55.6 3.3 CAPEX -13.3
6 EBIT 8.3
7 Tax expense 0 Tax creditor 0 0 0 Tax paid 0
8 Cash 0 0 0 Cash increase 0
9 EBI or NOPAT1 8.3 IC increment1 58.9 55.6 3.3 FCF1 5.0
10 Interest expense 0 Interest creditor 0 0 0 Interest paid 0
11 Debt 0 0 0 Debt issue 0
12 Dividend -5.0 Dividend creditor 0 0 0 Dividend paid -5.0
13 Equity shares -50.0 -50.0 0 Equity issue 0
14 Retained -3.3 Equity reserves -8.9 -5.6 -3.3
Finance cash
15 Finance loss1 -8.3 Financial capital1 -58.9 -55.6 -3.3 -5.0
flow1
Statement of Recognised Income and Expense SORIE
17
Lectures 1 - 3
2.9 Summary
Investing = -Financing
18
Lectures 1 - 3
Answers
1. IS, BS and CFS
2. IS less BS increment = Cash Flow Statement
3. NOPAT less IC increment = FCF
4. EBITDA plus depreciation less WC (excluding cash) increment = CFO
5. Sales – Expenses – Depreciation - Tax
6. Debtors + Stock + Creditors + Tax Creditor + Cash
7. 0%
8. 10% * (1-75%) = 2.5%
9. financing flow
10. When there is no interest paid and no debt and equity share issues
11. IC increment > NOPAT
12. When customers > suppliers
13. BS increment for creditor
14. Look for positive NPV investment opportunities or buy back their debt and equity
15. EP = NOPAT – Capital charge
16. By the discounting effect
19
Lectures 4 - 8
Note that (1) and (4) value the whole company, that is debt plus equity, whereas (2) and (3)
value only the equity component and must have the debt component added to get the whole
company value. Think of invested capital as debt + equity.
Table 13 from Lectures 1-3 repeated
Invested capital IC 55.6
Interest creditor 0
Debt Debt 0
Dividend creditor 0
Equity shares Equity -50.0
Equity reserves -5.6
Financial capital Debt + Equity -55.6
We will apply each model in turn, to the company data matrix of chapter 2, and illustrate that
all the models are equivalent. They generate the same value for the company regardless of
which model you choose.
1
Lectures 4 - 8
We forecast the FCF to grow at 10% a year for the first five years and indeed to continue to
grow at 10% to perpetuity.
Table 2
t0 t1 t2 t3 t4 t5 t6 to perpetuity
Free cash flow
5.0 5.5 6.1 6.7 7.3 8.1
FCF
2 3 4 5
Discount at 15% 1/(1.15) 1/(1.15) 1/(1.15) 1/(1.15) 1/(1.15) 1/(1.15)5
growing at 10%
1/(0.15 - 0.10)
PV(FCF) =
Value of 100.0 4.3 4.2 4.0 3.8 3.6 80.1
company
Alternatively
Value of company0 =PV(NOPAT1-t – IC increment1 - t)
This alternative expression can be derived from model (1) as follows:
Value of company0 = PV(FCF1-t) (model(1))
FCF = NOPAT – IC increment (definition of FCF in chapter 2.4)
Value of company0 =PV(NOPAT1-t – IC increment1 - t) (substitution)
2
Lectures 4 - 8
Where D1 = dividend1 and r = discount rate for equity and g = growth rate
alternatively
Value of equity0 = D1/Dividend yield
3
Lectures 4 - 8
Table 5
Row BS
P&L P&Lt1 BS BSt1 BSt0 CFS CFSt1
number incrementt1
1 Sales 100.0 Debtors 0 0 0 Customers 100.0
2 Stock 0 0 0
3 Expenses -81.7 Creditors 0 0 0 Suppliers -81.7
4 EBITDA 18.3 WC 0 0 0 CFO 18.3
5 Depreciation -10.0 FA 58.9 55.6 3.3 CAPEX -13.3
6 EBIT 8.3
7 Tax expense 0 Tax creditor 0 0 0 Tax paid 0
8 Cash 0 0 0 Cash increase 0
9 NOPAT 8.3 IC increment 58.9 55.6 3.3 FCF 5.0
10 Interest expense 0 Interest creditor 0 0 0 Interest paid 0
11 Debt 0 0 0 Debt issue 0
12 Dividend -5.0 Dividend creditor 0 0 0 Dividend paid -5.0
13 Equity shares -50.0 -50.0 0 Equity issue 0
14 Retained -3.3 Equity reserves -8.9 -5.6 -3.3
Finance cash
15 Finance loss -8.3 Financial capital -58.9 -55.6 -3.3 -5.0
flow
We forecast the earnings less IC increment to grow at 10% a year for the first five years and
indeed to continue to grow at 10% to perpetuity.
Table 6
t0 t1 t2 t3 t4 t5 t6 to perpetuity
Earnings less
5.0 5.5 6.1 6.7 7.3 8.1
IC increment
2 3 4 5
Discount at 15% 1/(1.15) 1/(1.15) 1/(1.15) 1/(1.15) 1/(1.15) 1/(1.15)5
growing at 10%
1/(0.15 - 0.10)
PV(Earnings
less IC 100.0 4.3 4.2 4.0 3.8 3.6 80.1
increment)
add Debt 0
Value of
100
company
4
Lectures 4 - 8
Alternatively
Value of equity0 = Earnings1 * PER
This is a multiple based model rather than discounting based, the multiple being PER. PER is
Price0/Earnings1 where price is used here synonymously with value
Table 7
Row BS
P&L P&Lt1 BS BSt1 BSt0 CFS CFSt1
number incrementt1
1 Sales 100.0 Debtors 0 0 0 Customers 100.0
2 Stock 0 0 0
3 Expenses -81.7 Creditors 0 0 0 Suppliers -81.7
4 EBITDA 18.3 WC 0 0 0 CFO 18.3
5 Depreciation -10.0 FA 58.9 55.6 3.3 CAPEX -13.3
6 EBIT 8.3
7 Tax expense 0 Tax creditor 0 0 0 Tax paid 0
8 Cash 0 0 0 Cash increase 0
9 NOPAT 8.3 IC increment 58.9 55.6 3.3 FCF 5.0
10 Interest expense 0 Interest creditor 0 0 0 Interest paid 0
11 Debt 0 0 0 Debt issue 0
12 Dividend -5.0 Dividend creditor 0 0 0 Dividend paid -5.0
13 Equity shares -50.0 -50.0 0 Equity issue 0
14 Retained -3.3 Equity reserves -8.9 -5.6 -3.3
Finance cash
15 Finance loss -8.3 Financial capital -58.9 -55.6 -3.3 -5.0
flow
Table 8
NOPAT1 8.3
less:
Interest expense 0
Earnings1 8.3
PERcomparable company 12
Value of equity0 100
add Debt0 0
Value of company0 100
Alternatively
Value of equity0 = Earnings1/Earnings yield
The multiple based model can be reconfigured as a discounting model so long as the discount
rate used is the earnings yield. The reciprocal of P/E is E/P, which is yield. In this example the
yield would be 1/12 or £8.3/£100 or 8.3%. So instead of multiplying by PER, divide by
earnings yield.
Table 9
NOPAT 8.3
less:
Interest expense 0
Earnings 8.3
Earnings yield 1/ 8.3%
Value of equity 100
add Debt 0
Value of company 100
This version of model (3) collapses into model (2), which used dividend yield with dividends.
We now use earnings yield with earnings.
5
Lectures 4 - 8
Note the relation of dividend yield and earnings yield and the discount rate r.
Where
r = dividend yield + g
In our example:
15% = 5% + 10%
and
r = (earnings yield – incremental investment/value) + g
In our example:
15% = (8.3% - 3.3%) + 10%
Some investment managers treat earnings yield as the discount rate r to be applied to cash
flows in an NPV appraisal. Since the yield is likely to be lower than the discount rate r these
managers may over invest (invest in –ve NPV investment opportunities).
Some individual investors assume that a low PER, that is a high yield, company has low
growth when in fact it may be that the company’s cash flows are high risk.
Yield 8.3% = r 15% + incremental investment/value 3.3% - g 10%.
Table 10
yield r measures incremental g
risk investment/value
12 or 8.3% 15% 3.3% 10%
high PER or low earnings yield
? ? ?
say 120 or 0.8%
low PER or high earnings yield
? ? ?
say 2 or 50%
6
Lectures 4 - 8
5 Use the discounted stream of NPVs model or the two component model (4)
7
Lectures 4 - 8
This formula is essentially the formula for the present value of a constantly growing
perpetuity, which you met in chapter 1.3.3. The book value component is valued as a stream of
normal earnings. Normal earnings are earnings which just cover the discount rate, in this case
£8.3/£55.6 = 15%.
8
Lectures 4 - 8
Value0 = PV(FCF1-t)
We may increase the free cash flow (FCF) but only by investing in riskier opportunities.
Table 15
t0 t1 to perpetuity
Free cash flow FCF 5.0
Discount at 5% 1/(0.05)
PV(FCF) = Value of company 100
Table 16
t0 t1
Free cash flow FCF 50.0
Discount at 51% 1/(0.51)
PV(FCF) = Value of company 98
Maximising cash flow ignores the trade off which is the risk of the cash flow. The value is not
the sum of the cash flows but the sum of the risk adjusted cash flows.
We may increase the dividend1 but only by foregoing growth and the resulting sacrifice of
future dividends.
Table 17
t0 t1 to perpetuity
Dividend 5.0
Discount at 15% growing at 10%
1/(0.15 - 0.10)
PV(Dividend) 100.0 100.0
add Debt 0
Value of company 100.0
Table 18
t0 t1 to perpetuity
Dividend 8.3
Discount at 15% growing at 0%
1/(0.15 - 0.00)
PV(Dividend) 55.3 55.3
add Debt 0
Value of company 55.3
Maximising the dividend at t1 ignores the trade off which is future dividend.
9
Lectures 4 - 8
Table 20
t0 t1 to perpetuity
Earnings 8.3
IC increment 4.2
Free cash flow 4.1
Discount at 15% growing at 20% * 50% = 10%
1/(0.15 - 0.10)
PV(Dividend) 82 82
add Debt 0
Value of company 82
Maximising the earnings ignores the trade off, which is the level of investment required to
earn those earnings.
Only one variable, NPV, bears a direct relation with company value such that maximising it
will also always maximise company value. There are no trade offs with NPV.
10
Lectures 4 - 8
Maximising the IRR ignores the trade off which is the size of the cash flows.
11
Lectures 4 - 8
ARR has many names: Return on Capital Employed (ROCE), Return on Net Assets (RONA)
and Return on Invested Capital (ROIC). ROIC is used here and is measured as:
ROIC1 = NOPAT1/IC0
However some companies, operating in very high risk environments, estimate such high
discount rates that distant cash flows are discounted back to zero. Such aggressive discounting
is almost equivalent to using payback as a selection measure.
12
Lectures 4 - 8
12 Summary
The CEO is aiming to maximise value. This is why he is incentivised on Total Shareholder
Return (TSR).
So he manages value
TSR = Value1 – Value0 / Value0
where
gconstant = ROICincremental investment * Investment rateconstant
and where
Investment rateconstant = Retained profit1/NOPAT1
13
Lectures 4 - 8
13 Quick questions
1. List the five valuation models
2. What is wrong with maximising cash flow?
3. What is wrong with maximising dividends?
4. What is wrong with maximising earnings?
5. What does a high PER imply?
6. What does a high yield imply?
7. Define IRR
8. What is wrong with maximising IRR?
9. What is wrong with maximising ARR?
10. What is the unique property of NPV, which makes it the only efficient investment
selection measure?
11. Which investment selection measure may be used in very high-risk environments?
Answers
1. (1) the discounted cash flow approach
(2) the current earnings plus future investment opportunities approach
(3) the stream of dividends approach
(4) the stream of earnings approach
(5) the PER multiple approach
2. Cash flows ignore risk
3. Dividends ignore growth
4. Earnings ignore size of investment
5. Either high g or low risk
6. Either low growth or high risk
7. The discount rate where NPV = £0
8. IRR ignores the size of the cash flows
9. ARR ignores size and risk of the cash flows
10. Maximising the investment’s NPV always maximises the company’s value because only
NPV bears a direct relation with value such that
Value = Book + Goodwill or PV(NPVs)
11. Payback
14
Lectures 6 - 8
Cash flow
improve ROIC g
Return on Invested Capital growth strategy
£10m/£100m to £20m/£100m £10m/£100m to £20m/£200m
Margin Productivity
NOP/Sales Sales/IC
37.4% 0.61
ROIC
9.15%
Pretax ROIC
10.2%
Margin Productivity
NOP/Sales Sales/IC
7.5% 1.35
The ROIC Tree and Expenses
Margin
NOP/Sales
7.5%
Profitability and
Productivity
Strategic Plan
Cash flow
improve ROIC g
Return on Invested Capital growth strategy
£10m/£100m to £20m/£100m £10m/£100m to £20m/£200m
cut BS costs
productivity
The ROIC Tree
ROIC
NOPAT/IC
9.15%
Margin Productivity
NOP/Sales Sales/IC
7.5% 1.35
Productivity
Sales/IC
1.35
BS Stock
Production raw materials £0
Production in progress £0
Production finished goods £40
Retail goods £0
Data Sheet and Debtors
WC as a % of sales
FA as a % of sales
Trade off between Margin and
Productivity
If the FA are old then:
Productivity high because FA/Sales low
But
Margin low because Expenses/Sales
high because asset keeps breaking
down because old
Lectures 9 - 10.xlsdebt policy
Market imperfections create an opportunity to offer financial services to the investor and so achieve financial competitive advantage (value added from financing):
debt policy market imperfection/asymmetry financial service value added from financing
if an investor wants leveraged equity Modigliani and Miller "… you can't
the investor can borrow to buy shares make the pizza bigger by slicing it differently …"
the arbitrage proof: by giving a bigger slice to debt
if Vleveraged > Vunleveraged say profit = 10 and Ke = 15% and Kd = 5%: return%
then arbitrage opportunity E (= Dividend/Ke) + D (= Interest/Kd) = profit/WACC 30% Ke (see topic 1)
but arbitrage forces convergence E (=7.5/0.15)= 50 + D (=2.5/.0.05)= 50 = 10/0.1 = 100
so Vleveraged = Vunleveraged WACC = 15% * (50/50+50) + 5% * (50/50+50) = 10% 15%
say add leverage: 10% WACC
Value and WACC stay the same 10/0.1 = 100 5% Kd
E (=6.0/0.3)= 20 + D (=4.0/0.05)= 80 = 10/0.1 = 100 D/E
WACC = 30% * (20/20+80) + 5% * (80/20+80) = 10% 50/50 80/20
D/E
as Ke from 15% to 30%
so E from £50 to £20
Note that weights must be market values
15%*50/100 + 5%*50/100 = 30%*20/100 + 5%*80/100
BUT not the same asset:
high debt tax law interest shields profit from tax tax saving = interest * tax rate
high profit asymmetric treatment of only available where see topic 13 for examples of calculations
companies debt interest 1. profit to be shielded the examiner uses an after tax WACC
equity dividends 2. FC for security
why not 100% debt ?
limited by financial distress costs
high debt agency theory limits directors' discretionary spending agency cost saving
high cash flow asymmetric behaviour of of free cash flows
companies agent under debt P 10 10 see MBO and LBO industry
FCI -ve or nil NPV equity company finances
-10
agent under equity WCI managers to buy out an ugly duckling
Free Cash Flow 0 10 ugly duckling = plus agency costs
Dividend is discretionary 0 unwanted by its parent focusing on value = good supply
Interest is not discretionary -10 leverage
Financing flow 0 -10 and sell on to a new investor company as a swan
high debt informaton asymmetry between debt issue informs the market that new issue discount in after market cost saving
low profit manager and investor not making a share issue so
companies such that debt issue = good news 1. shares not overpriced
equity issue = bad news may even be underpriced
2. debt not exhausted
high debt credit risk asymmetry use company's credit rating investors' interest cost saving
high credit rated between company and individual
companies such that company cheaper
Vleveraged = Vunleveraged + PV(tax savings) + PV(agency cost saving) + PV(new issue discount in after market cost saving) + PV(investors' interest cost saving)