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1

Capital budgeting

Decisions to determine profitability of individual projects
—make decisions and shape firms future - evaluate and plan for purchase of LONG TERM assets - budget to inc. value

Vital for entrepreneurs- info. To investors

2

3 criteria to evaluate capital budgeting

1. Examine ALL cash flows that occur during the life of the project (positive or negative) - consider all future cash flows too

2. Consider the timing of those CFs (TVM)

3. Considers risk using RRR - risk and return directly correlated, risk inc. = return INC. - acct. for both when evaluating projects

3

1. Payback period

# years to recover the IO - # years it takes to pay for itself - earn back original investment

how to know if acceptable project?
--usually firms set standard - only projects with payback 4 years or less accepted

weakness: subjectivity - mgmt. sets standard when all projects are accepted
--does not account for TVM or for risk through RRR - can't distinguish btw highly risky project and sage inc.

used bc quick - or in small businesses - best to be used as precursor to other methods

4

2. NPV

Meets all 3 criteria
--similar to IRR, but NPV expressed in terms of dollars and IRR as a percentage

NPV = sum (net) of PV of all projects expected Bfs (outflows or inflows), discounted to present time - then subtract IO

IT IS THE DCF Equation with CF on top and (1+k)^t as denominator
--then subtract IO (initial outlay and time 0)

take each Indiv. ANNUAL CF and discount to present by dividing each by a discount factor of (1+k)^t and add all PVs together - then subtract original investment

NPV = the diff. btw PV of our future earnings and value of out initial investment

if POSITIVE = we expect to earn more than we invest
--means PV of benefits > IO

if NEGATIVE = we reject project - IO is more than PV of inflows to be rec. in future

5

NPV in calc. 2 ways

npv(rate%, IO, {CF1, CF2,...},{N1,,N2...})
npv(15,-276499,{83000,116000},{4,1}) = 18,235.71

OR
find first annuity of 4 pmts. then the final pmt. inc.
pt. 1 = FV = 0, I = 15, N=4, pmt. = -83000, PV = 236,963.2041
pt. 2 = FV = 116,000, PMT = 0, N=5, I = 15, PV = 57,672.501

Add 2 PVs then subtract IO
294,635.705 - 276,499 = 18,235.705

ACCEPT PROJECT

Common mistake is to think that NPV must be > IO - no true - bc already subtract out IO when solving...so if positive (even if small), PV of cash inflows > cash invested so accept!!

6

Profitability index - PI

Pvalue of FCFs divided by IO
if PI > 1 - means pV FCF > IO(cost of project) so INVEST

one of NPV issues is w do not have a sense of return in percentage terms generated by the investment
--can see that NPV = 10,000 looks good...but if saw IO was 1000 = really good return!! but if IO = 1,000,000, getting 10,000 return is not that high...don't reject bc positive but what to know how good inv. was

PI - gives mgmt. a sense of return

It is the DCF formula with CF as numerator divided by (1+k)^t ALL DIVIDED by IO

there is NO PI button on calculator - so to solve you do the NPV with IO = 0 in the formula
--then divide the answer you get by IO

ex. NPV(15,0,{83000,116000},{4,1}) = 294,635.7054
then divide answer by 276,400 = 1.07
>1 so accept

interpret amt. return PI = 1.07 means that for every $1 a firm invests it rec. a .07 cent return
--PI DOES NOT REPLACE NPV = USE BOTH

it is GOOD, but most use IRR bc specific - can't determine PI as a return (least used...was almost at bottom of chart)

7

iRR - internal rate of return

discount rate that makes the NPV = 0
--want it to be HIGH
--if IRR > Discount rate = accept project

IRR = rate of return that firm earns on its capital projects - it is easiest method for ppl to interpret and communicate (% return we are making not the investment)
--breakeven point in NPV (Rate where benefits = cost)

when NPV = 18,235.71 - does not mean we will rec. a check of that amt....it means that 18,235.71 is the amt. in present terms that the value of firm will INC. bc of the project

INC. Discount rate = DEC. NPV ---cont. to raise discount rate until NPV = 0

IRR = is the NPV formula (DCF) but instead of subtracting IO we set it = to iO
--solving for the discount rate - finding rate that makes PV of FCFs = to IO

YTM = was the rate that made bond's inflows and outflows equal - YTM with bonds is IRR with real investments

can be solved by trial and error

DECISION
--If IRR > RRR = accept!!!
--if IRR < RRR = Reject!!

8

calc. IRR in calculator

IRR(IO,{CF1,CF2...},{N1,N2...})
EX. IRR(-276400,{83000,116000},{4,1}) = 17.69%
--(just leave out the % rate)

if 17.69% > RRR = accept!!
if < RRR = not profitable given its level of risk

advantage is IRR considers TVM

for NPV we use WACC to calc. the dollar benefit of project to company - but in IRR, we calc. the actual return then compare it to cost of capital (WACC)

9

problems with IRR

1. Additivity problem - considering multiple projects - but have capital restraints - not best decision to do all with highest IRRs until run out of capital
--IRRs cannot be directly compared across projects - can't use IRR to choose btw mutually exclusive projects
--NPV better to compare other projects bc can see dollar benefit from each project - IRR is harder to tell bc can have a high return if a project has a low IO compared to others...but that doesn't mean that NPV is high

2. Cash flow patterns - IRR works well only when project CFs are conventional (beg. with negative IO then series of positive CFs)
--unconventional are when projects have multiple sign changes in CF stream --- makes it possible to calc. more than 1 IRR - every time there is a sign change brings a new IRR
--SOLUTION: use NPV
--ex. after IO, t1 positive, t2 negative, t3 positive = three sign changes so 3 possibles IRRs

10

special case = mutually exclusive projects with unequal lives

two options: WACC for bot = 12%
1. printer has 3 yr. life
cost = 10,000, NPV = 2577
2. book press has 6 yr. life
cost = 20,000, NPV = 3245.47

unequal lives bc replace one in 3 and one in 6
two ways to solve:
1. replacement chain
2. equivalent annual annuity (EAA)

mutually exclusive = can do one project but CANNOT do both - bc budget constraints

11

Replacement chain method - for mutually exclusive projects with unequal lives

two options: WACC for bot = 12%
1. printer has 3 yr. life
cost = 10,000, NPV = 2577
2. book press has 6 yr. life
cost = 20,000, NPV = 3245.47

1. replacement chain
--equalize lives of both projects by stacking projects toe last common life period
in ex. - least common life period = 6 years (book press for 6 or two printers for 6 years total) - add together and force to have same life

so calc. NPV of buying 2 printers
in cash flow diagram (numbers will be T)
0 -10,000
1 3500
2 6500
3 6000 (-10000 (When buy 2nd printer)) = -4000
4 3500
5 6500
6 6000
NPV = 4412.01
IRR = 25.2%

Can now compare NPVs bc have 6 year lives on both
--so choose the two printers bc higher NPV!!!

Good but hard when least common period is large - 17 years and 12 years has closest common of 204 years - so time consuming so use EAA method

12

EAA method (equivalent annual annuity) - for mutually exclusive projects with unequal lives

two options: WACC for bot = 12%
1. printer has 3 yr. life
cost = 10,000, NPV = 2577
2. book press has 6 yr. life
cost = 20,000, NPV = 3245.47

2. EAA METHOD
annuity method with same life, discount rate, ad PV as the poorest - NPV "Per year" - annualize NPV!!

solve for PMT in TVM problem
1. 6 yr. press PV = -3,245 (find by NPV), n = 6, I = 12, FV = 0
--Solve PMT = 789 (means if choose, impact will be equivalent to rec. $789 per year (ANN NPV)

2. 3 yr. printer, PV = -2577, N = 3, I = 12, FC = 0
--Solve PMT = 1073 - benefit $1073 per year

decision close higher EAA - so printer!!!
(might have to solve for PV of each by finding NPV of each first..then use!!)

13

capital budgeting class notes

which projects to invest in - LEFT SIDE OF BALANCE SHEET (assets)
--L & E is then capital structure - M&M
--Capital budgeting on left is corporate finance - how to use L and EE to buy certain assets

criteria
1. TVM
2. Objective decision rul/ RRR
3. ALL cash flows (positive and negative)

14

7 methods to capital budgeting

ALWAYS HAVE TO DO ALL 7
1. Payback
2. Discounted payback
3. NPV
4. PI (profitability index)
5. Integrated.modified IRR (MIRR)
6. Internal rate of return (IRR)
7. Avg. accounting rate of return (AARR)

Might all say YES, or all say NO - or have a mix of yes or no...in that case use NPVs answer

BUT NPV and IRR are the BEST

REWATCH THIS LESSON!!!

15

2. Discounted payback

TVM to discount each future CF
--then do the payback method

16

5. modified IRR (MIRR)

assumed reinvest at IRR
--FIXES problem - how? by allowing us o DEFINE THE REINVESTMENT RATE (that will be the test question)
--not on test bc easiest to compute on excel

17

7. AARR

average accounting rate of return
--NPV is better...but like. bc audited and standard - ppl with strong accounting background prefer

AVE. NI / AVG. book assets
NI Assets
2019 100 1000
2020. 110 900
2021. 130 800
=340 / 3. = (900 ave.)
(the assets side is the net depreciation - depreciation effects)

= 113.3 / 900 = AARR = 12%

fails all 3 criteria but common to be using it so need to know

AVE. NI / AVE. book assets > Target ROA (return on assets)
---becomes NI / TA (Watch lecture again)

18

DCF class notes

valuing an inv. by determine PV of its FCF - an Inv. is acceptable if its calc. payback period is < some pre-specified period of time

Inv. is acceptable if its iIRR > RRR

(NPV = 0) means IRR = another way to say it

more than one discount rate = multiple rates of return

19

problems with IRR class notes

1. reinvestment assumption (read in book again)
--fixed by using MIRR (allows us to say what reinvestment rate should be)

2. addituity problem
--ranking projects - rank each project by NPV to choose order to finance projects - then when budget runs out...stop
--solution: use NPV

3. switching sings
--solution: NPV

4. order of cash flows
ex. project 1 has IO then LARGE Cfs at beg. --- small CFs
project 2 has IO, then little CFs at beg. ---> large CFs
--result: NPV and IRR might disagree bc TVM

5. size of project ---> IO
--IRR is biased to small projects
--solution: use NPV

IRR = Return you are going to need to break-even

20

conditions to use EAA or replacement change

if two projects have:
1. diff. lives
2. mutually exclusive (need one truck, choose btwn 2 - can't have both)
3. repeatable
--then use EAA or replacement change

if doesn't have ALL THREE, then use NPV to determine

21

choose ranks from NPV or IRR for budgeting problems?

Rank projects from HIGHEST NPV to LOWEST NPV
---NOT IRR

22

capital bugeting quantitative notes

quantitative Analysis important but does not make decisions for us
--it is an "input to wisdom"

IMPORTANT NOTE
1. when doing capital budgeting, want to understand overall impact of project on company ("look at project from CEO's office)
2. idea of incremental CF prevents others from allocating CF (expenses) to our project
---any costs that incur regardless of whether it accepts the project should not be included in evaluation of project

23

Incremental cash flows

CF that arise that are directly related to a specific project and COULD NOT OCCUR otherwise
--additional CF in or out of firm created as a result of choosing the project (Rev. expenses, taxes, costs)

incremental CF = CASH IN - CASH OUT (exclude all non-incremental CF)

includes incidental CF and OPP. COST but NOT sunk costs

cost of heating, lighting, maintaining plant is not cost of project bc comp. was already paying for it

24

Incidental CF

there are obvious DIRECT incremental CF and also indirect, incidental CF (less obvious) - can make HUGE diff. but not as easy to recognize

ex. sell tan for 11cents - less than bought it - lose $ on direct sales of tuna, but gain $ on indirect sales of bread, mayo and celery

ex. in bus. world - cost of cannibalizaion is an incidental CF - if launch a. new product that will steal (or cannibalize) some of sales of another company's products - loss of sales is an incidental CF caused by a new product

BUT DEPENDS ON CIRCUMSTANCES
--Intel launches new comp. chip and sales of old chip fall - competitor would try and steal their market share
--either way sales of old chip dec. bu in first case, did not lose market share
--works bc TECH. is fast-paced and constantly growing - cars...if replace it is incidental bc cars take longer to design, develop, and produce

25

sunk costs

"sunk" when cost is irretrievable - irrelevant to our analysis and decision making - in past and done
--given knowledge we have today, cost of project going fwd. and its projected rev.

26

opp. cost

using land cash equip. time - loss of ability to use that same asset toward the next best project
-build warehouse for $40 million parcel of land? - is that $ included in cost of project?? yes! even though already have it. There is opp. cost that it can't be used any where else

incremental CF = CF created by project minus was h out
--include incidental and opp. cost but NOT sunk costs
--then must consider our depreciation expenses

27

2 types of expenses

1. CURRENT expenses
--outlays for goods and services that will be used during the current year (gasoline for car - rec. full benefit from using gas that year)
--go directly to income stmt. as COGS, operating expenses, or other expense (interest)

2. CAPITAL expenses
--outlays for items that will provide a benefit to firm for MANY years - automobiles bc cars are not "used up" in single year
--cap. exp. do not flow directly to income stmt. - they are ASSETS on balance sheet - then shown as cost as dec. in value over time

28

depreciation expense

how capital expenses are allocated to cost of operations over time - dec. by estimated value of car by certain % each year
--deprec. exp. included on income stmt. as an operating expense
why? bc impacts TAXES - we are paying
--deprec. exp. influences our yearly CF by reducing our taxable income - taxes are a real CF

2 methods: MACRS and straight line depreciation

29

1. depreciation - MACRS

Modified accelerated cost recovery system
--an "ACCELERATED" depreciation system - based on a double declining balance system - operationalized but he tax code
--multiply cost of asset (depreciable basis) by same given %
--the exact % is determined by the U.S. gov. by estimated asset life categories (comp. 3 years, car 5 years)

ex. machine - 3 yr. plan and depreciable base = $100
yr. 1 33% = $33
yr . 2 45% = $45
yr. 3 15% = $15
yr. 4 7% = $7
total depreciation. = $100 exp.

in MACRS = each has one addition year of depreciation (7 years = 8 years, 10 years = 11 years)

the depreciable base will be the IO + installation costs

30

2. Straight line depreciation

(COST OF ASSEST - SALVAGE VALUE) / life
--calc. each year
--the salvage value is the market value you think you can sell it for at end of product's life

assumes that asset has 0 salvage value - so becomes cost / life annually
---not realistic that it will have NO value, but helps acc.
--adv. depreciation. is same eery yr. of asset's life, easy to calc.
--in real bus. method is rare used - MACRS preferred bc depreciates assets more quickly called "accelerated depreciation"

it might give you an ex. 100,000 cost, 20,000 salvage and 5 year life - but then explicitly say "salvage" to go to 0
--means when solve do (100,000 - 0)/5 = $20/yr.
--you would use the salvage value later when estimate capital gains for taxes - it would be mkt. value of 20,000 and book value of 0
s0 (20,000 - 0) * tax rate

31

why MACRS better?

time diff. signifiant bc TVM
--deprec. exp. affects taxable income - affects taxes
--more depreciation. exp. in one year = dec. taxable income and dec. taxes
--straight line method depreciates same amt. every year - depreciation

MACRS is good bc > amt. of depreciation in earlier years and less in end - so makes TAXABLE income and paid TAXES both smaller - so more money in pocket
--TVM money is worth more today than in the future - in MACRS push a lot of taxes off to later years
--PV of tax bill smaller with MACRS bc majority of tax exp. occurs later and will be discounted more heavily

depreciation is non-cash expense - don't write a depreciation check..just system that allows firms to expense cost of capital expenses over time (bc IMPACTS AMT. AND TIMING OF TAX PMTS. )

32

Net working capital

CURRENT ASSETS - CURRENT LIABILITIES
--the capital ended to operate in short term (day to day)
--many projects req. inc. in working capital (build up inv. and accounts rev.) as start of project
--as INC in assets - means build up of NWC
--all additional inventory bought to use in project
--NOT LONG TERM - ONLY SHORT TERM
--he will tell you percent you can recoup in final year (80-90%)

machine and raw materials and inputs - also extra raw materials for "Safety stock" in case of crisis, unexpected D or shortage

beg. = most expensive - initial, raw, and safety stock
yrs. = already have safety stock - only need enough to meet yrs. D
final = don't need safety stock so use and sell - liquidate all acc. rec.

standard convention:
--INC NWC = represents cash outflows early in project and cash inflows at end of project (At beg. invest in extra WC - cash outflow, at end of project we dec. WC and liquidate NWC to recoup original investment)

RULE: Any NWC (regardless of how accumulated) is liquidated at end of projects life - result is CASH INFLOW
--no tax effects in working cap. build up or liquidation

outflow - build up of NWC (time 0)
inflow = liquidate all NWC associated with project and end of life

33

the impact of taxes on capital budgeting

two tax situations
1. income tax - usually fixed marginal rate

2. tax on sale of equipment

Book value = cost - accumulated depreciation
BV < sale price (MKT VA) = there is taxable gain on profit
BV > MKT VALUE = taxable loss (shield)

34

1. income taxes and tax shield

any increase in income will be taxed at fixed marginal tax rate
--compute firm's incremental income tax by predicting project's revenues and subtracting expected expenses to find taxable income - then multiply by marginal tax rate

if marginal tax rate was 30% - and taxable income for a project was negative (-$100) that means somewhere else in comp. there is a positive income of $100 that would have been taxed but no won't to cover that negative - so actual saved company $30 in taxes

TAX SHIELD - tax savings from offsetting positive earnings with negative income

35

2. taxes in sale of an asset

--GAIN (not revenues) are taxed

ex. buy asset for $1000, depreciate to $600 then sell for $60 - profit was $0 on sale so tax liability is $0 - no gain

ex. 1 with gains - cost = 1000, acc. dep. = 400, tax rate = 40% and sale price = 100
--current book value = cost - acc. dep. = 1000-400 = 600
--sold for 100, so loss on sale - means should have claimed 900 for acc. depreciation value but only claimed 400 - loss of $500 on sale

BUT tax shield of loss
$500 * 40% = $200 - so this $200 tax savings represents money comp. now does not have to send to IRS and can invest in other opp. = real savings to comp.
(bc somewhere else in comp. they have a positive $500 that was going to be taxed and now won't bc it was used to cover the $500 loss)

cash impact of sale = $100 sales price + $200 tax savings = $300 total cash inflow!!

don't do on purpose - want rev. - only non-cash expenses that lead to "paper losses" are good for tax purposes

36

2. taxes in sale of an asset - tax GAIN ex.

cost = 1000, acc. dep. = 400, tax rate = 40%, sale price = 800

BV = 600, MKT. va = 800
= 200 profit/gain
--OVER depreciated the asset, bc should have only depreciated to 800 (acc. dep. 200)

200*.40 = $80 - real cash outflow for company
--net cash flow for sale = 800 sale - 80 (Tax) = 720
--sell asset for more than book value and lost some money on taxes (but also gained 120 so ok)

to find tax effects on sale of asset
--multiply (market va - BV) by tax rate

37

capital budgeting 3 steps

process of planning for LONG-term assets - see if purchases profitable t comp.

1. evaluate the CFs (IO, diff., terminal)
2. assess project risk
--risk of project same as risk for overall firm
--use firm's cost of capital (WACC) as discount rate for all capital investment projects

3. accept or reject the project
--calc. NPV, positive = accept, negative = reject
--also use IRR (and others from class notes)

38

1. evaluate the CFs - (1) IO

Purchase price of asset
+ shipping and installation costs
___________________________
=depreciable asset (can use MACRS or SL)
+ investment in working capital INC.
+/- after-tax proceeds from sale of old asset
_________________________________
= net IO


---shipping/instal (bc any cost incurred in order to acquire and start using as asset is a capital expense - therefore DEPRECIABLE) - also employee training on new machine - these costs not in income stmt but included in calc. annual depreciation exp.
--the inv. in working capital INC is only INCREMENTAL - (change in CA - CL) - what A and L change bc of project
--after-tax proceeds from sale - if not replacing OLD asset, just buying an additional machine - this will be $0 (this is what we just learned with tax bills (+) /shields (-)) - make sure it is OLD asset sales (many miss on test) - old asset market value (sale price) - old asset book VA

39

1. evaluate the CFs - (2) diff. CFs

cash flows resulting from operations of project each yr - need to be large enough on a discounted basis to justify our investment of project, if not large (NPV) then reject
--this is calc. the FCF each yr of the life of the project - CF generated after finding inc. in NWC, needs and req. capital expenditures
--use only incremental CFs

(MINI INCOME STMT)
INCREMENTAL value (Sales)
- incremental costs (Expenses)
- depreciation on project
____________________
= incremental earnings before taxes (EBT) (really EBIT - but assume equity fin. rn so no interest exp.
- tax on incremental EBT
__________________
= incremental earnings after taxes (NI)
+ DEPRECIATION REVERSAL
_________________________
= ANN. free cash flow

40

1. evaluate the CFs - (3) terminal CF

operate during ENTIRE final yr. so earn final year's diff./free CF, then dispose of machine at END of final year

realizable salvage value (it is the sales price or MKT value)
+/- tax effects of capital gain/loss
+ recapture of new working capital
____________________________
= terminal CF

LOOK AT PRACTICE PROBLEM EX. AFTER LEARN!!

--for recapture of NWC - he will tell you the percent you can recapture - usually 80-90% - it will be (CA - CL)*recap %
--tax effects of cap. gain/loss - M > B it is a gain and so will be a subtraction from this value, if M < B it is a loss so will be adding value bc don't lose that from taxes

the salvage value in this is NOT the same as the one used in SL dep. formula (cost - salvage)/life - this salvage value we use to find terminal is just the sale price of the asset

41

Cap. budgeting three parts ex. (some of it)

found the IO to be 635,000 (time 0)
--Diff. CF = 138,800 (yrs. 1-5)
--terminal = 70,000 which was (75000 salvage value - 30,000 tax on cap. gains, + 25,000 recoup of safety stock NWC - this is at time 5

so the terminal value was 138,800 + 70,000 which is Diff. CF for year 5 plus the terminal value for year 5
but when doing part 3 to find NPV you use include it as an additional CF in yr. 5

NPV at 15% WACC
NPV(15,-635000,{138800,208800},{4,1}) = Negative so REJECT

42

Balance sheet small ex. assets side

B.S. is a "snapshot" in time - can compare 2 to show change
--in order from most liquid to least liquid - liquid: turn into cash quickly without losing significant amt. of market value

A
current assets:
cash
marketable securities
accts. rec. (usually 30-60 days)
inventory
= total current assets

fixed assets
--gross fixed assets (PP&E) - prop. plant. equip.
less: (accumulated depreciation)
=net fixed assets

intangible assets
--brand value (1)
--good will - "overpay" in acquisition - target worth when M&A with company - overpay called good will
--patents
--trademarks
--copyrights
-trade secrets (recipe Coca-cola) (6)
=total LT assets

=total assets

"gross fixed assets" - means hasn't had depreciation taken out yet - plant and equip. are depreciable but property isn't

43

balance sheet L&E side

all historical - no market values!!

current liabilities
- Accts. payable (non interest bearing)
-accruals (non interest bearing - only 2)
--notes payable - bank loans
=total current liabilities

long-term liabilities
--mortgage debts (10-30 yrs)
--equipment loans (5 years)
= total LTD
=total liabilities (total debt)

Equity
--prof. stock (not common)
retained earnings (sum of all in company)
common stock
additional paid-in-capital
=total equity (M/B - mkt. cap/book value - market to book ratio)

Total L&E

for additional paid in capital and common stock use ex. of IPO - $10 Per share
--PAR VALUE = $1 and APIC = $9
--if 10M shares outstanding....
common stock = ($1 * 10M) = $10M on B.S.
APIC = $9 * 10M = $90M on B.S.

44

income stmt.

called P & L by entrepreneurs/consultants - profit and loss
--only need 1 income stmt. - shows HOW changed over time

revenues (top line - need marketing)
-COGS
________
Gross profit
-operating expenses (SG&A, wages, utilities)
_______________
EBITDA (entrep. fin. - proxy for CF)
-depreciation expense
_______________
EBIT (also called OPERATING INCOME)
-interest
___________
EBT (TAXABLE income)
-tax expense
___________
Net income (EARNINGS, PROFIT) - bottom line

NI = dividends + change in retained earnings
new RE = old RE + change in RE
New RE = old RE + NI - div

45

historical cost in finance

DON'T CARE about historical cost in finance - only care about market value
there was problem and we don't care about the 98,000 historical cost
--nor sunk cost of 10,000
--but can sell for 50,000 and that is the value bc it is opp. cost if we don't

46

stmt. of cash flows all we need to know

CFO - operations
CFI - investment
CFF - financing

47

FASB and GAAP

FASB - fin. acc. standards board - create rules for GAAP
--Judgment involved, so can't do acc. all by computers
--rules based

families use cash based acc. - when cash comes in, record

accrual based acc. used by businesses - math rev. with expenses in same period - when incurred

48

ratio analysis important to analyze company performance for 4 reasons

1. standardize
--fin. data - ace it comparable across firms (even if diff. sizes) - or compare to its own performance in the past

2. flexibility
--not determined by GAAP or rules so easily adapted to any situation/need
--analyst chooses how many yrs. data to use - which ratio to calc. - invent new ratios

3. leads us to look in right places so we correctly understand current performance and position of comp.
--ratios don't answer ?s about comp. - the tell you which ?s to ask!! - show us what is changing and we ask WHY

4. helps us evaluate whether firm is achieving its stated goal to max shareholder wealth
--pubclicly trade comp. belongs to shareholders
--principle agent - when agent (manager) is not acting in best interest of the principle (owner) - resulting costs are agency costs
--help evaluate mgmt. actions to see if they are fully exploiting the firm's earning potential - can compare performance to past or competitors

49

4 things ratios look at

1. liquidity
2. asset use efficiency
3. financing
4. profitability

50

1. liquidity ratios

1. CURRENT RATIO = current assets / current liabilities
--shows whether comp. can meet its short term obligations using cash or near cash assets
--INC. ratio = more likely to repay

2. QUICK ratio = (current assets - inventory) / current liabilities
--if low - creditors nervous - uses most liquid assets

3. ACP - AVERAGE COLLECTION PERIOD
= AR / daily credit sales
--is # of days on ave. it takes for a company to collect its account receivables
--the daily credit sales are ANN credit sales / 365
--if = 32...means if comp. sells goods today, on ave. it will take 32 days for comp. to collect cash

4. AR turnover = credit sales. AR
--# of times a firm's AR acct. turns per year
--= 12, means comp. collects its AR 12 times per year (about once a month)

5. INVENTORY TURNOVER = COGS / inventory
--# times firm sells its inventory annually

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2. efficiency ratios

measures how well comp. uses its assets to generate profits or sales - efficiency of mgmt.

1. TOTAL ASSET TURNOVER = sales / total assets
--how many dollars in sales the firm generates for every dollar of assets it owns
=3, for every dollar of assets, it generates $3 in sales

2. FIXED ASSET TURNOVER = sales / fixed assets
--sales produced per dollar for fixed assets

3. Operating income return on investment (OIROI)
--tells how much pre-tax, pre-financing profit a comp. earns per dollar of assets] - also a profitability ratio
--if $100 made on 1000 asset portfolio = 100/1000 = 10% return

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3. financing ratios - leverage ratios/solvency

--describes what proportions the firm uses equity and or debt to finance those assets

1. DEBT RATIO = total debt/ total assets - what proportion of the firm is financed with dent
--optimal debt ratio - amt. of dent that minimizes firm's cost of capital

2. Times interest earned (TIE) = EBIT/ interest exp.

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4. Profitability ratios

based on sales or asset investment - analyze how well mgmt. is doing at max. shareholder wealth

1. ROA = NI / total assets
--compares ANN. NI to total asset base - used to generate - how profitable firm is given its asset investment

2. ROE = NI/ EQUITY - compares ANN NI to total equity
---if a firm is effectively using debt to finance, the ROE / ROA

3. gross margin = gross profit / net sales
operating margine = EBIT / sales
net margin = NI / SALES
--5%, for every dollar os=f sales, 5 cents drop to NI

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DUPONT Decomposition

ROE = NI / E = (NI / S)* (S / A)* (A / E)

1. Net profit margin = NI / sales - PROFITABILITY - measures firms efficiency in controlling costs

2. Asset turnover - EFFICIENCY - how efficiently firm is using assets to generate sales

3. Leverage multiplier

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3 levers to INC. ROE

1. we can dec. costs and hold sales constant = INC NI

2. we can INC. sales while holding assets constant (INC. asset turnover)

3. we can INC. debt, while holding equity constant (lever up = LBO advantage)

if drop the leverage multiplier from DuPon
ROA = NI / S * S / A
--allows u to remove impact of debt from leverage factor

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ROIC - return on invested capital

ROIC = NOPAT / (costly capital)
net operating profit after taxes
costly capital = all interest bearing debt and total equity

ROIC adv. - measures retune regardless of whether fin. comes from D or E

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FCFF - free CF to the firm

SO IMPORTANT - How you value a company!!!
cash left over after operations and taxes available to creditors and shareholders

FCFF = EBIT - cash taxes + depreciation - CAPEX - INC in NWC
--EBIT - cash taxes use bc want to find leftover for creditors and debtors - so need interest
--taxes - income stmt.
--depreciation - income stmt. or 2 B.S. - no cash flowing out

--CAPEX (cap. expenditures - GROSS fixed assets over one b.S. - GROSS fixed assets from prev. year = PP&E - Gross means haven't taken out depreciation...so if give net...have to add back in one year of depreciation

--CHANGE IN NWC = (CA - CL)2040 - (CA-CL)2039

include CAPEX and NWC bc they are Increases in assets, which use up a firm's cash

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FCFE

value to find what stock should be trading at (value equity portion of firm - CFs leftover for equity holders after all comp. operations and after paying creditors (interest)
--cash leftover ONLY to shareholders

NI + depreciation - CAPEX - INC. NWC + NC. in NET LTD
--LTD - If take MORE debt it INC CF bc more cash to work with

IT - FCFF if company has no debt in its capital structure
in ex. = -590 - means they paid off a lot of debt - be nervous bc need more cash..can't pay off dent
--could be red flag depending on company response - tells us what ?s to ask mgmt

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EVA - economic value added - or economic profit

approach by Stern Stewart company - termed it "Economic value added"

economic profit - accountants discovered that acc. profit, measured by NI (earnings) doesn't accurately portray firm's profits bc does not consider OPP. COSTS
--want to know opp. cost of all NI holding

EVA incorporates both cost of debt and cost of equity

EVA = NOPAT - [WACC * Costly capital]
NOPAT = EBIT - taxes - income to firm not including interest exp.
--costly capital - all interest bearing debt (NP and LTD) and all equity

in ex.

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three main comparison methods used in ratio analysis

1. trend analysis - past

2. cross sectional analysis (peers/ comp./ industry)

3. measure progress to achieve goals

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cash I finance

CASH IS KING

Toys R us has positive FCFF but negative FCFE

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DuPont class notes

ROE = NI / E = (NI / S)*(S / A)*(A / E)
1. Net profit margin - PROFITABILITY lever
2. Total asset turnover - EFFICIENCY lever - for every $1 in assets we have, how many dollars in sales
3. leverage multiplier

CAN ONLY FOCUS ON ONE LEVER - first who try to do more than one fail

2nd way to write: ROE = (NI / S)*(S / A)* [(D / E) + 1)

3RD way: ROE = (NI / S)* (S / A) / [1 - (D / A)]