Business and Project Valuation
A business's assets can be valued by summing the market capitalisation of equity (E) and debt (D).
But for private businesses whose equity and debt doesn't trade on an active liquid market, and for business projects, assets must be valued directly.
Valuing a business or a project is very similar to pricing a stock or bond. It can be done using discounted cash flows (DCF, same as NPV) or multiples valuation techniques. We will focus on DCF.
The two main difficulties with business and project valuation are:
- Forecasting future cash flows. Often, even trying to calculate and classify past historical cash flows can be difficult due to the high level of aggregation in accounting statements.
- Forecasting future expected required returnswhich are related to systematic risk.
In this class we’ll focus on cash flows, especially how to calculate the cash flows from the firm's assets using accounting statements. Most of our figures will come from the income statement and balance sheet which are the publically available reports published by all listed companies.
In a laterclass we’ll discuss different ways to calculate the total required return of an asset which is related to the capital asset pricing model (CAPM) and the weighted average cost of capital (WACC).
The Income Statement for Just Jeans Group
Just Jeans GroupIncome Statement for
period ending 26 July 2008
Net sales / 822
COGS / 717
Depreciation / 24
EBIT / 81
Interest expense / 11
Taxable income / 70
Taxes / 21
Net income / 49
Note: all figures are given in millions of dollars ($m).
The Income Statement as an Equation
Where: Net Income, Revenue,
Cost of Goods Sold, Fixed Costs per yr
Depreciation expense Interest expense
Corporate tax rate
Let's check that it works for Just Group. Assume a corporate tax rate of 30%.
, which is the same as the income statement.
Firm Free Cash Flow (FFCF)
FFCF is the 'firm free cash flow', also called 'cash flow from assets' (CFFA).It's the cash flow from the assets V(= D + E).
The main differences between FFCF and NI are that FFCF:
- is a cash flow so it takes timing differences into account. For example, it excludes accrual items such as depreciation (), but includes the actual cash flows such as capital spending () on buildings and other assets.
- includes opportunity costs ().
- excludes financing expenses ().
Net Capital Expenditure (CapEx)
Net Capital Expenditure (CapEx) is the cash spent buying (or upgrading) assets less the cash received from selling assets. The assets are supposed to be non-current assets like land, buildings, trucks, equipment, patents and so on. Note that a positive change is an increase and would correspond to a net buying of assets.
Remember that CapEx is supposed to be a cash flow, so depreciation (Depr) must be ignored. There are two ways to calculate CapEx:
GFA is Gross Fixed Assets, usually just Gross PPE (Property, Plant and Equipment), and
NFA is Net Fixed Assets, usually just the carrying amount of PPE. So:
Increase in Net Working Capital (ΔNWC)
Net Working Capital (NWC) is Current Assets (CA) less Current Liabilities (CL):
The Change or Increase in Net Working Capital () is:
Why the Increase in NWC is subtracted from FFCF
NWC will increase when, say, lots of inventory is bought but not sold, or more money ends up in the cash register, or when any other current asset increases (or current liability decreases).
Increases in the amount of cash sitting in the cash register is not an expense, but it is money that could be in the bank earning interest. Therefore it is an opportunity cost that needs to be included. Similarly for inventory sitting around. Therefore any increase in net working capital needs to be subtracted since it is a cash flow not included in NI.
Calculation Example: ΔNWC
Question: Imagine if Just Jeans purchased $100 million worth of clothes as inventory from overseas and kept them in a warehouse all year without selling any.
Question 1:What would be the effect on the firm's net income (NI) that year?
Answer: Nothing. An accountant will only expense inventory when it is sold (in COGS). In this case nothing is sold so there is no impact on the profit.
Note that we're assuming that there is no inventory write-off. If there was, then there would be an expense and profit would fall.
Question 2: What was the opportunity cost of having the $100m inventory sitting around for one year if interest rates are 5% pa, given as an effective annual rate?
Answer: The opportunity cost would be $5 million (=0.05 x $100m), but the accountant would not record this anywhere in the financial statements.
In a financial valuation, this opportunity cost would be included as a fixed cost (FC) per time period in the FFCF equation.
Interest Expense (IntExp)
Interest expense is calculated by accountants as the bond or loan price multiplied by the yield. This is called the 'effective interest method'.
- Important note: interest expense is unrelated to coupon or interest payments, so even a 5 year zero-coupon bond will have an annual interest expense.
Firm free cash flow (FFCF) should not add or subtract cash flows to the investors who finance the assets because otherwise FFCF would be zero.
This is because FFCF equals the cash flows paid to the debt and equity holders.
Equity dividends and buybacks, as well as debt interest and principal, should be ignored from FFCF, except for their tax effects.
Financing Cash Flows
Financing cash flows are:
- Debt-holders’ cash flow ()including coupons, principal and loan payments, less any new raisings such as bond issues (borrowing or selling new debt); plus
- Equity holders’ free cash flow () including dividends and buybacks, less any new raisings such as rights issues or placements (selling new shares).
Where:
Why FFCF = Financing Cash Flows
FFCFmust always equal the equity-holders’ dividends and buybacks plus the debt-holders’ coupon and principal payments, less any raisings (selling new equity or debt):
- Note that FFCF, EquityFCF and DebtCF are defined in the narrow sense as cash flow only, not capital gains.
FFCF will always equal the net cash flows to debt and equity holders because who else should be paid the FFCF besides these rightful owners?
- If the firm keptthis year’s cash flow generated in the bank, it may appear that FFCF is higher while neither the debt nor equity-holders receive the cash flows, breaking the above equality.
But remember that any increase in the firm’s cash holdings will result in a change in net working capital (ΔNWC) which is subtracted from FFCF, so keeping cash in the bank will not increase FFCF at all.The equality holds.
- If the firm uses its cash to re-invest and buy more assets, it may appear that FFCF is higher while neither the debt nor equity-holders will receive the cash flows, breaking the equality.
But remember that any increase in the firm’s assets will result in capital expenditure (CapEx) in the case of buying buildings or machines, or an increase in net working capital (ΔNWC) in the case of buying inventory, and both are subtracted from FFCF, so they will not increase FFCF at all.The equality holds.
Why Financing Cash Flows are Ignored
If all financing costs such as equity dividends and buybacks together with debt coupons and principal were subtracted from FFCF, then there would be nothing left since:
So:
Thereforeit’s best not to subtract financing costs such as dividends, buybacks, interest or principal payments from FFCF, otherwise the assets’ FFCF will be zero and the present value of this will also be zero so your assets will appear worthless, when in fact they could be very valuable!
Why Interest Expense is Added to FFCF
Net income is polluted since it subtracts interest expense, a financing cash flow. That's why interest expense is added back in the FFCF equation:
Note that the interest expense still affects FFCF due to taxes - the ‘interest tax shield’ effect. We’ll discuss this later.
Dividends are not subtracted or added in the NI equation, therefore they are not added back or subtracted from the FFCF equation. They are entirely ignored since they are a financing cash flow.
FFCF Equation
FFCF equals Net Income...
- Plus Depreciation (Depr), because it is subtracted in NI . We reverse it because depreciation is not a cash flow.
- Less net Capital Expenditure (CapEx), since the cash flow from buying buildings must be subtracted.
- Less the Increase in Net Working Capital ().
- Plus Interest Expense (IntExp), because it is subtracted in NI . We reverse it because Interest Expense is a ‘financing expense’ which has nothing to do with the assets themselves.Also, interest expense is an accrual, it is not a cash flow. This is apparent when considering that zero-coupon bonds incur interest expense. Accountants define interest expense as the debt price at the start multiplied by its current yield.
Calculation Example: FFCF of Just Group
Just Jeans Group / Just Jeans GroupIncome Statement for / Balance Sheet as at 26 July
period ending 26 July 2008 / 2008 / 2007
Net sales / 822 / Current A / 92 / 105
COGS / 717 / Non-current A / 195 / 178
Depreciation / 24 / Total A / 287 / 259
EBIT / 81
Interest expense / 11 / Current L / 208 / 72
Taxable income / 70 / Non-current L / 22 / 134
Taxes / 21 / Owners Equity / 57 / 53
Net income / 49 / Total L and OE / 287 / 259
Note: all figures are given in millions of dollars ($m).
Question: Find the FFCF using the income statement and balance sheets
Assume that non-current assets is completely made up of Net Fixed Assets.
Answer:
We need to calculate and from the changes in the balance sheet.
, so net capital expenditure rose over the year.
, so net working capital fell over the year.
Equation Summary
Notes:
Cash Flow From Assets (CFFA) is another name for FFCF.
FFCF equals Equity Free Cash Flow (EFCF)plusDebt Cash Flow (DebtCF) payments to debt holders. Note that payments to debt holders should be actual cash flows of principal and coupon or loan payments, not interest expense which is an accrual, such as when interest is expensed on a zero-coupon bond.
Questions: Firm Free Cash Flow (FFCF) or Cash Flow From Assets (CFFA)
1