determinants of a firm’s value

Prepared by Waseem Ahmad

Determinants of a Firm’s Value

Sales Operating Required Financing Interest Firm Market

Revenues Cost & Investment Decisions Rates Risk Risk

Taxes in Operations

Free Cash Flows(FCF)

Weighted Average Cost of Capital

(WACC)

Value = FCF1 + FCF2 + FCF3 + ……..+ FCF

1 2 3 (1 + WACC) (1+WACC) (1 + WACC) (1+WACC )


Financial Statements, Cash Flow and Taxes Management`s Primary Goal is to maximize the value of

Company`s Stock Value depends upon the ability of the Company to generate

stream of cash flows in the future. Investor estimate future Cash Flow`s of Company by studying

its annual report. Annual report contains both Descriptive and Financial

Information about the Company. Descriptive section contains CEO report, Auditor report,Future

plans, information about Company`s products etc. Financial Portion contains FOUR basic Financial Statements

ie., Balance Sheet, Income Statement, Cash Flow and Statement of retained earnings Plus last 10years key Financial results.


Financial Statements report what has actually happened to Assets, earnings, and dividends over the past year/s. Whereas, verbal statements explain why the things turned out the way they did.

The information contained in the Annual report is used by the investors to form expectations about the future earnings and dividends.


Balance Sheet

A Traditional Balance Sheet tells us the Financial position of a Company on a particular point in time.

Balance sheet equation is

Assets = Liabilities + Owner`s Equity.


M/s Micro Drive Balance Sheet ($ in Mil)31 December 2003 / 2004

Assets 2004 2003Cash &Eqvlts 10 15Shrt Term Invst 0 65Accounts Rcvbl 375 315Inventories 615 415 Ttl C/Assets 1000 810Net Plant&Eqpt 1000 870

Total Assets 2000 1680

Liab&Equty 2004 2003

A/c Pybl 60 30

Note / Payable 110 60

Accruals 140 130

Ttl C/Liablities 310 220

L.Term Bonds 754 580

Total Debt 1064 800

P.Stock(400000) 40 40

C.Stock(50000000) 130 130

Retained Earnings 766 710

Total Com Eqty 896 840

Ttl Liab & Eqty 2000 1680


Micro Drive IncIncome Statementfor the Year ending 31 Dec 03/04 (In Millions)

2004 2003Net Sales 3000 2850

Operating Cost Excldg Dep/Amtzn 2616.2 2497Erng b4 Int,Tax,Dpcn&Amtzn(EBITDA) 383.8 353Depreciation 100 90Amortization 0 0Depreciation &Amortization 100 90Earning before Int&Tax (EBIT or Op Incm) 283.8 263less interest 88 60Earning before Tax (EBT) 195.8 203Taxes @ 40 % 78.3 81.2Net Income before Preferred dividend 117.5 121.8Preferred Dividend 4 4Net Income 113.5 117.8Common Dividend 57.5 53Additions to retained earnings 56 64.8


Per Share Data 2004 2003

Common Stock Price 23 26

Earning per share (EPS) 2.27 2.36

Dividends per Share(DPS) 1.15 1.06

Book Value per share(BVPS) 17.92 16.80

Cash Flow per Share(CFPS) 4.27 4.16

EPS= Net Income / Comn Shares Outstanding

113,500,000/50,000,000= 2.27DPS = Dividend Comn Stkholdrs/ Comn Sh/O

57,500,000/50,000,000 = 1.15

BVPS = Total ComEqty/Comn shares Outstdg

896,000,000 / 50,000,000= 17.92

Cash flow per share(CFPS) = Net Incm +Depreciation + Amortization /

Common Share Outstading

213500000/ 50,000,000 = 4.27


STATEMENT OF RETAINED EARNINGS

Changes in retained earnings between balance sheet dates are reported in the Statement of Retained Earnings.

Retained earnings represent`s a Claim against Assets. Retained earnings are used for Business Expansion purpose ie., investing in Assets .The retained earnings is not CASH nor available for payment of Dividends or any thing else Micro Drive Inc (Millions $)

Retained Earning Statementfor the year ending 31 Dec04

Balance of retained earnings , Decmeber 31, 2003 710Add Net Income 2004 113.5Less Dividends to common stock holders (57.5)

Balance in retained earnings, December 31, 2004 766.0


Cash Flow StatementCash Flow Statement provides information about the cash receipts and cash payments of a

business during the accounting period because of Operating, Investing and Financing

activities.

A Business’s Net Cash Flow is different from Accounting Profits

Net Cash Flow = Net Income - Non Cash Revenues + Non cash Charges.

Net Income: Other things held constant, Positive net income likely to result positive cash flow

(Net Income can be used for Dividend payments, Increase in Inventories, Finance A/R,

Investment in Fixed Assets, To reduce debts , To buy back common stock etc .

Non cash Adjustment to net income: Non cash revenues and expenses are adjusted.

Changes in Cash Balances :

- Increase in current Assets other than CASH (Invt, A/R) decreases Cash and vice versa

- Increase in Current Liabilities increases CASH and vice versa

- Fixed Assets: Investment in fixed assets reduce cash and vice versa

- Securities Transactions: If a Co issues Stock, Bonds during the year, the funds raised will

increase Cash position, On the other hand if it ( uses cash ) buy back outstanding stock, pay

off debt, dividends to share holders it will reduce the Cash .


Contents of Cash Flow Statement

The Cash Flow statement separates activities into 3 categories

plus a Summary section:

1. Operating Activities: Cash effects of revenue & expense transactions. Cash effect of those activities which are reported in Income Statement.(Net Income,Depreciation and changes in C/A & C/L other than Cash ,S/Term Investment, and Short term debt).

Cash receipts: Collection from customers for sale of goods

and services, Interest and Dividend received, Other receipts from operations eg., proceeds from settlement of litigation.

Cash Payments: Payments to suppliers of Merchandise and

Services, including payment to employees.Payment of interest, Payment of Income taxes, Other expenditure relating to operations eg., payment in settlement of litigation.


Investing Activities

2 Cash Flow relating to Investing Activities present the cash

effects of transactions involving Plant Assets, Intangible

Assets, and Investments (Investment in or Sale of Fixed

Assets).

Cash Receipts: Cash receipts from selling investments or

plant assets, Cash Collection -- collecting principal

amounts of loans-- (for banking co).

Cash Payments: Payments to acquire investments or plant

assets, Amount Advanced to Borrowers ( for banking co).


Financing Activities

Financing Activities: It includes raising cash by selling short

term investments or by issuing short term debt, long term

debt, or stock. It also includes the impact of Dividend

payment, cash used to buy back outstanding stock or bonds .

Cash Receipts: Proceeds from sale of short term and long

term borrowing, Cash received from Owners eg., from

issuing stock.

Cash Payments: Repayments of amount borrowed

(excluding interest payments), Payments to owners such as

dividends.


What questions Cash Flow statement tries to answer

Financial Managers use this Cash Flow statement along with

the Cash Budget when forecasting the Companies cash

position. Cash flow statement answers the following

questions:

Is the Company generating ENOUGH cash to purchase

additional assets which are required for growth. Is the Company generating extra cash that can be used to

repay debts or invested in new products.

Profits reported in Income statements can be manipulated

(doctored) whereas it is far more difficult to manipulate

working capital simultaneously with profits. The Company

can declare profits right up to the point of bankruptcy.


Micro Drive:Statement of Cash Flows for 2004 ($ in Mill)

1 Operating Activities Cash provided / Used

Net Income b4 preferred dividend $ 117.5

Adjustments

Non Cash Adjustments:

Depreciation 100.0

Due to Change in Working Capital

Increase in A / R (375-315) (60.0)

Increase in Inventories (615-415) (200.0)

Increase in A / Payables (60-30) 30.0

Increase in Accruals (140-130) 10.0 Net Cash provided by Operating Activities ($2.5)


2. Long term Investing Activities.

Cash Used to acquire Fixed Assets(130+100) ($230)

Total Funds used by Investing Activities ($230)

3 Financing Activities

Sale of Short term Investment (65-0) $ 65.0

Increase in Notes Payables (110-60) 50.0

Increase in Bonds Outstanding (754-580) 174.0

Paymnt of Dvdnt (Comn 57.5+ Prefd 4) (61.5)

Net Cash provided by Financing activities 227.5

SUMMARY:

Net Changes in Cash ($5.0)

Cash at beginning of the year 15

Cash at the End of the year $ 10


MODIFYING A/CING DATA FOR MANAGERIAL DECISIONS

Different Companies have different Financial Structures,

Tax situations which can affect Return on Equity. 2

Companies having similar operations appear to be operating

under different efficiency.

Performance of Managers should be judged on the basis of

their performance on the Operating assets which are under

their control. (EBIT to be compared with Operating Assets)

Assets can be classified as:

Operating Assets: Those assets which are used for the core

activities of the business.

Non operating Assets: Used for Non core activities. Eg.,

Cash and short term investment held above level of normal

operations.


Classification of operating assets:Operating Current Assets: Assets necessary to operate business eg., Inventories , Accounts receivablesLong term operating Assets: Such as Plant and Equipment.

Note: IF SAME AMOUNT OF PROFIT / CASH FLOW CAN BE GENERATED WITH LESS AMOUNT OF INVESTMENTS IN OPERATING ASSETS --- LESS

CAPTIAL / FUNDS REQUIRED TO BE PROVIDED BY THE INVESTORS. IT WILL INCREASE RETURN ON CAPITAL AND LESSON COST OF CAPITAL. OPERATING CURRENT LIABILITIES

Fund provided by the Normal Consequence of business are called operating Current Liabilities e.g., Accounts Payable, Accrued wages and Taxes etc . NOTE: THESE ARE FUNDS WHICH ARE NOT PROVIDED BY THE INVESTOR RATHER GENERATED AS A

CONSEQUENCE OF BUSINESS OPERATIONS.


If a Company needs $100 millions of Assets but it has $10

millions of Accounts Payable and $ 10 millions of Accrued

wages and Taxes then the Investor supplied capital would be

only $ 80 millions. 100 - (10+10) = 80

Operating Working Capital: Current Assets used in

operations are called Operating Working Capital.

Net Operating Working Capital: Operating Working Capital

less Operating Current Liabilities is called Net operating

working capital.

NOWC= All current Assets that do not pay interest MINUS

All current liabilities that do not charge interest.

Or

NOWC= Operating Current Assets MINUS

Operating Current Liabilities.


Cash , Inventories , Accounts receivable are required for

Normal Business operations by all Companies.

Any Short term security which a Company holds results from

INVESTMENT decision I.e not required for Core activities.

Current Liabilities that charge interest such as note payable to

bank, are treated as investor supplied capital where as

current asset Accounts payable / Accruals are as a result of

normal business operation.

NOWC= (Cash+ A/R+ Inventories ) -(A/P + Accruals)

Total Operating Capital: (NOWC) + (Operating LT Assets)


NET OPERATING PROFIT AFTER TAXES (NOPAT)

In order to calculate better measurement of the

performance of the managers we compute NOPAT.

This is amount of profit which a company will generate

if it held no Debt and Financial Instrument.

NOPAT = EBIT (1-Tax rate)

For more complicated tax situations

NOPAT = (Net income before preferred Dividend)+

(Net Interest expense ) (1-Tax rate)


FREE CASH FLOW

NET CASH FLOW = NET INCOME + NON CSH ADJMT

OPERATING CASH FLOW= NOPAT + DEPRECIATION

FCF= The Cash flow actually available for distribution to

Investors after the company has made all the investments in fixed

assets and working capital necessary to sustain ongoing

operations.

In order to make company more valuable the managers should try

to increase the amount of FCF

FCF= Operating Cash Flw - G Investment in Oprting Assets.

Or FCF = NOPAT - Net Investment in Operating Assets.


USES OF FCF

Five Good Uses of FCF

Pay Interest to debt holders, keeping in mind that the net cost to the company is the after tax interest expense.

Repay debt holders that is pay off some of the debt Pay dividends to share holders Repurchase stock from the share holders Buy marketable securities or other non operating asset.

FCF is not used for acquiring operating assets FCF should not be used in unnecessary Investments which do not Add Value . FCF can also add in Agency Cost.

FCF is the cash available for distribution to Investors. Therefore, the value of Company primarily dependent upon its expected future FCF.


EVALUATING FCF, NOPAT & OPTNG CAPITAL

Negative FCF is not a sign of worry . Companies normally

in expansion phase or High growth Co can have negative

FCF.

IF NOPAT as well as FCF both are negative than it is sign

of WORRY. It means company is experiencing

OPERATING problems.

WHETHER the GROWTH is Profitable a measure

ROIC is computed ( Return on Invested Capital).

ROIC= NOPAT / OPERATING CAPITAL

IF ROIC > WACC (If ROIC is greater than return investors

demand ) The company is ADDING VALUE.


MVA and EVA

Primary goal of Management is to Maximize share holder

wealth.This will benefit Share holders and result in efficiently

allocating funds in the economy.

The share holder wealth is maximized by MAXIMIZING the

difference between the market value of the stock and the

amount of Equity Capital. It is called MARKET VALUE

ADDED.

MVA= MARKET VALUE OF STOCK MINUS EQUITY

CAPITAL SUPLLIED BY SHARE HOLDERS.

Or

MVA=(Shares outstanding X stock price) Minus

Total Common Equity.


The HIGHER the MVA the better the JOB management doing.

THE MVA is some time defined the total market value of the company

MINUS the total amount of investors supplied capital

MKT Value of (Equity + Debt + Preferred stock) MINUS

Total Common Equity + Debt+Preferred Stock.

MVA Measures the effects of Managerial Actions since the Inception of

the Company.

EVA ECONOMIC VALUE ADDED

EVA focuses on Management performance in a given year.

EVA= NOPAT minus AFTER TAX $ COST OF CAPITAL USED TO

SUPPORT OPERATIONS.

Or EVA = EBIT(1-T) minus (Operating Capital) X (WACC)

or EVA = (Operating Capital) x ( ROIC-WACC)


IF ROIC > WACC then Company will have +ve EVA IF WACC > ROIC then new investment in OPERATING CAPITAL

will reduce the firm VALUE. EVA is an estimate of TRUE economic profit for the period and it

differs SHARPLY from Accounting Profit. EVA represents the Residual Income that remains after all the

COST of CAPITAL , including Equity Capital has been deducted whereas Accounting profits are determined without consideration of equity capital cost.

IN EVA we do not add back Depreciation. EVA measure the extent to which Company has added to the

Share holders value. EVA can be determined for all divisions as well as company as a

Whole. It becomes the basis for evaluating performance of Management at ALL LEVELS.

IF a Company has history of NEGATIVE EVA then probably MVA will also be negative.


THE CO with Negative EVA can have Positive MVA

provided INVESTORS expects a turnaround in future.

EVA is used for evaluation of Management performance and

management compensation.

MVA Calculations:

2004 2003

Price per share 23 26

Number of Shares (Mill) 50 50

Market Value of Equity 1150 1300

Book Value of Equity 896 840

MVA added= Mkt Value

minus Book Value 254 460


EVA Calculation: 2004 2003

EBIT 283.8 263

Tax rate 40% 40%

NOPAT=EBIT(1-T) 170.3 157.8

Total Invs Supplied Capital 1800 1455

After Tax cost of Capital 11% 10.8%

(WACC)

$ Cost of Capital = Capital 198 157.1

X (WACC)

EVA=NOPAT-Capital Cost (27.7) 0.70

ROIC= NOPAT/ Optng Captial 9.46% 10.85

ROIC-Cost of Captl= ROIC-WACC (1.54%) 0.05%

EVA= Optng Capital(ROIC-WACC) (27.7) 0.7


How to compute Operating Capital

Investor supplied operating capital equals the sum of note payable,Long term debt, preferred stock, and common equity, less short term investments.

It could also be calculated as total liabilities and equity minus accounts payable, accruals and short term investments. It is also equal to total net operating capital.

Yr 2004= NP 110, LTB 754, PRF STK 40 EQUITY 896 = 1800YR2003 = 60 , 580, 40, 840 - 65 = 1455

OR FOR 2004 = 2000 - (60 + 140) = 1800 FOR 2003 = 1680 –(30+130+65) = 1455

determinants of a firm’s value

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