Corporate Finance Dr.

Ridha ESGHAIER

CHAPTER 4
Cash Flows & Major
Financial indicators

Dr. Ridha ESGHAIER

Chapter Plan
 Part 1. Major Financial Statements
– Balance sheet
– Income statements
– Statement of retained earnings
– Statement of stockholders’ equity
– Statement of cash flows
 Part 2. Major Financial indicators
 Working Capital & Operating Working Capital
 Total Operating capital
 Net CF, Operating CF
 Free cash flow to the Firm, Free cash flow to Equity
 The cash flow identity : Cash flow to creditors and cash flow to shareholders
 Economic value added (EVA)
 Market value added (MVA)

2
 Dr. Ridha ESGHAIER

LEARNING OUTCOMES
The student should be able to:
a. describe how the different activities of the company affect
its cash position and prepare the statement of cash flows;
b. calculate and interpret the cash flow from operating
activities, the CF from investing activities and the CF from
financing activities;
c. calculate and interpret the net working capital and the net
operating working capital of a company;
d. calculate and interpret the free cash flow to the firm (FCFF)
and the free cash flow to equity (FCFE) from NI; EBIT, CFO
and EBITDA;
e. calculate and interpret the cash flow to creditors and the
cash flow to stockholders and check the cash flow identity;
f. calculate and interpret the market value added (MVA) and
the economic value added (EVA) of a company.
3

Dr. Ridha ESGHAIER

Part1. Major Financial

Statements

• Balance sheet
• Income statements
• Statement of retained earnings
• Statement of Stockholders’ Equity
• Statement of cash flows

4
 Dr. Ridha ESGHAIER

1. The Balance Sheet

A financial statement that summarizes a company's assets, liabilities
and owner’s equity at a specific point in time. It provides a snapshot of
the firm’s financial position at a particular point in time
ASSETS LIABILITIES & OWNER'S EQUITY

. Cash . Accounts payable

. S-T investments (Marketable securities) . Notes payable - Liabilities that involve Formal
Degree of Liquidity

Order of Payability
loan agreement with interest
. Accounts Receivable . Accruals payments (Bank loans,…)
Treasury Bills
- Liabilities which continually occur but are not
. Inventories Certificates of deposit,
supported by an invoice or a written demand
Commercial papers, …
for payment (taxes, utility charges, wages…)

Total Current Assets Total Current Liabilities

. L-T Financial assets (inv in other businesses) . Long-term debt
. Property, Plant, and Equipment . Preferred Stock
. Intangible Assets . Common Stock
Total Fixed Assets . Retained Earnings

Total Assets Total Liabilities & Equity

Dr. Ridha ESGHAIER

Balance sheet: Assets

year (n) year (n-1)

Cash 7,282 57,600
Acc. Rec 632,160 351,200
Inventories 1,287,360 715,200
Total [Link] 1,926,802 1,124,000
Gross Fixed Assets 1,202,950 491,000
(Depreciation) (263,160) (146,200)
Net Fixed Assets 939,790 344,800
Total Assets 2,866,592 1,468,800

6
 Dr. Ridha ESGHAIER

Balance sheet:
Liabilities and Equity
year (n) year (n-1)
Accts payable 524,160 145,600
Notes payable 636,808 200,000
Accruals 489,600 136,000
Total CL 1,650,568 481,600
Long-term debt 723,432 323,432
Common stock 460,000 460,000
Retained earnings 32,592 203,768
Total Common Equity 492,592 663,768
Total L & E 2,866,592 1,468,800
7

Dr. Ridha ESGHAIER

Market vs. Book Value

• Book value = the balance sheet value of the

assets, liabilities, and equity. The amounts
shown on the balance sheets are called
book values because they are based on the
amounts recorded by bookkeepers when
assets are purchased or liabilities are issued
• Market value = true value; the price at
which the assets, liabilities, or equity can
actually be bought or sold. It’s the current
values as determined in the marketplace
 Dr. Ridha ESGHAIER

2. The Income Statement

Also known as the "profit and loss statement”

Measures a company's financial performance over a specific

accounting period by summarizing its revenues and expenses over a
given period of time.
Net sales
– Operating costs excluding depreciation and amortization
= EBITDA (Earnings before interest, taxes, depreciation and amortization)
– Depreciation
– Amortization
= EBIT, or operating income (Earnings before interest and taxes)
– interest
= EBT (Earnings before taxes)
– Taxes
= Net income

Dr. Ridha ESGHAIER

Income statement
year (n) year (n-1)
Sales 6,034,000 3,432,000
- Cost of Goods Sold 5,528,000 2,864,000
- Other expenses 519,988 358,672
= EBITDA (13,988) 209,328
- Depr. & Amort. 116,960 18,900
=EBIT (130,948) 190,428
- Interest Expenses 136,012 43,828
= EBT (266,960) 146,600
- Taxes (40%) (106,784) 58,640
= Net income (160,176) 87,960

10
 Dr. Ridha ESGHAIER

Other data

year (n) year (n-1)

Nber. of shares 100,000 100,000
Earnings/PS = NI/Nber shares -$1.602 $0.88
Dividend/PS = Div/Nber Shares $0.11 $0.22
Stock price $2.25 $8.50
Book Value/PS $4.93 $6.64
= Tot [Link]/Nber of shares

11

Dr. Ridha ESGHAIER

3. The statement of retained earnings

The Statement of Retained Earnings explains the change in the
retained earnings for a specific period of time.
Retained earnings are the amount of income left in the
company after dividends are paid.

Retained earnings at the end of (n-1)

+ Net income of the period
– Dividend paid
= Ending retained earnings for the period (n)

12
 Dr. Ridha ESGHAIER

Application 1: Construct the Statement

of Retained Earnings for year (n)

Balance of retained
earnings, 12/31/year (n-1) $203,768
Add: Net income, year (n) (160,176)
Less: Dividends paid ($0.11x100,000) (11,000)
Balance of retained
earnings, 12/31/year (n) $32,592

13

Dr. Ridha ESGHAIER

Comments about the retained

earnings
• Note that “retained earnings” does not represent assets but is instead a
claim against assets. In year (n-1) the company’s stockholders allowed it
to reinvest $66,000: ($0.88 – $0,22)x100,000 shares) instead of
distributing the money as dividends, and management spent this money
on new assets. Thus, retained earnings, as reported on the balance
sheet, does not represent cash and is not “available” for the payment of
dividends or anything else.
• The amount reported in the retained earnings account is not an
indication of the amount of cash the firm has. Cash (as of the balance
sheet date) is found in the cash account, an asset account.
• A positive number in the retained earnings account indicates only that in
the past the firm earned some income, but its dividends paid were less
than its earnings. Even though a company reports record earnings and
shows an increase in its retained earnings account, it still may be short of
cash. 14
 Dr. Ridha ESGHAIER

4. Statement of Stockholders’ Equity

Changes in stockholders’ equity during the
accounting period are reported in the statement
of stockholders’ equity.
Nber of Amount of Retained Total Equity
common common Earnings
Shares shares
Balance Dec. 31, (n-1) 100,000 $460,000 $203,768 $663,768
+ Net Income ($160,176) ($160,176)
- Cash Dividend ($11,000) ($11,000)
Issuance of common Stock 0 $0.0
Balance Dec. 31, (n) $460,000 $32,592 $492,592

15

Dr. Ridha ESGHAIER

5. Statement of Cash Flows (SCF)

• Essentially, the cash flow statement shows how much cash comes
in and goes out of the company over the year.
• It is a financial statement that reports the impact of a firm’s
activities on cash and cash equivalent over a given period of time,
and breaks the analysis down to operating, investing, and financing
activities.
• The SCF sheds light on (i) the effects of earning activities on cash
resources, (ii) what assets are acquired, and (iii) how assets are
financed. It also can highlight more clearly the distinction between
net income and cash provided by operations. The ability of an
enterprise to generate cash from operations (CFO) on a consistent
basis is an important indicator of financial health. No business can
survive over the long run without generating cash from its
operations. However, the interpretation of CFO figures and trends
must be made with care and with a full understanding of all
surrounding circumstances.
• As an analytical tool, the statement of cash flows is useful in
determining the short-term viability of a company, particularly its
ability to pay bills. 16
 Dr. Ridha ESGHAIER

SCF, income statement

and Balance Sheet
• At first glance, the CFS sounds a lot like the income statement in that it
records financial performance over a specified period. But there is a big
difference between the two.
• Because the income statement is prepared under the accrual basis of
accounting, the revenues reported may not have been collected. Similarly,
the expenses reported on the income statement might not have been
paid. You could review the balance sheet changes to determine the facts,
but the cash flow statement already has integrated all that information.

When the income statement shows net income of $100, this

does not means that cash on the balance sheet will increase
by $100. Whereas when the bottom of the cash flow
statement reads $100 net cash inflow, that's exactly what it
means. The company has $100 more in cash than at the end
of the last financial period. 17

Dr. Ridha ESGHAIER

Statement of Cash Flows

Companies produce and consume cash in different ways, so
the cash flow statement is divided into three sections plus a
summary section :
– CF from Operating activities
– CF from Investment activities
– Cf from Financing activities

Basically, the sections on operations and financing show how

the company gets its cash, while the investing section shows
how the company spends its cash.

18
 Dr. Ridha ESGHAIER

Cash Flow from Operations

• This is the key source of a company's cash generation. It is the
cash that the company produces internally as opposed to funds
coming from outside investing and financing activities.
• In this section of the cash flow statement, net income (income
statement) is adjusted for non-cash charges and the increases
and decreases to working capital items (operating assets and
liabilities in the balance sheet's current position).

In short, operating activities involve the net income adjusted for

non-cash charges and changes in operating current assets and
operating current liabilities (CA and CL other than cash, short-term
investments and short term debt

19

Dr. Ridha ESGHAIER

Cash Flow from Investing

• For the most part, investing transactions generate cash outflows,
such as capital expenditures for plant, property and equipment,
business acquisitions and the purchase of investment securities.
Inflows come from the sale of assets, businesses and investment
securities.
• For investors, the most important item in this category is capital
expenditures. It's generally assumed that this use of cash is a prime
necessity for ensuring the proper maintenance of, and additions to,
a company's physical assets to support its efficient operation and
competitiveness.

In short, investing activities involve the purchase and/or sale of long-term

investments and property, plant, and equipment.

20
 Dr. Ridha ESGHAIER

Cash Flow from Financing

– Debt and equity transactions dominate this category.
Companies continuously borrow and repay debt. The issuance
of stock is much less frequent. Also because both dividends
paid and cash used to buy back outstanding stock or bonds
reduce the company’s cash, such transactions are included
here.
• For investors, particularly income investors, the most
important item is cash dividends paid. It's cash, not profits,
that is used to pay dividends to shareholders.

In short, financing activities involve the issuance and/or the repurchase

of a company's own bonds or stock as well as short-term and long-term
borrowings and repayments.

21

Dr. Ridha ESGHAIER

Statement of Cash Flows

 Operating activities include:
• Net income,
• Adjustments for depreciation,
• Changes in current assets and liabilities other than cash, short-term
investments and short term debt
 Investing activities include:
• investments in fixed assets (Gross)
• or sales of fixed assets
 Financing activities include:
• Raising cash by selling short-term investments (from CA) or by issuing
short-term debt (notes payable)  ST investments  cash from financing
 ST investments  cash from financing
• Changes in Long term debt, or stock
• Dividends paid and cash used to buy back outstanding stocks or bonds
22
 Dr. Ridha ESGHAIER

Understanding the changes

in Cash
• When you use cash to buy a book, you now own the book (you've increased your
"assets") but you also have less money (you've decreased your cash).
Based on what you learned, you can make the following general assumptions:
– When an asset (other than cash) increases, the Cash account decreases
– When an asset (other than cash) decreases, the Cash account increases
– When a liability increases, the Cash account increases
– When a liability decreases, the Cash account decreases
– When owner's equity increases, the Cash account increases
– When owner's equity decreases, the Cash account decreases

• Here's a Tip:
- For a change in assets (other than cash), the change in the Cash account
is in the opposite direction.
- For a change in liabilities and owner's equity, the change in the Cash account
is in the same direction.
23

Dr. Ridha ESGHAIER

Application 2: What is the Statement of Cash

Flows (year (n))
 OPERATING ACTIVITIES
Net income (year (n)) (160,176)
Add (Sources of cash):
Depreciation (from the income statement) 116,960
Increase in Accounts Payable (524,160 - 145,600) 378,560
Increase in accruals (489,600 -136,000) 353,600
Subtract (Uses of cash):
Increase in Accounts Receivable (632,160 - 351,200) (280,960)

Increase in inventories (1,287,360 - 715,200) (572,160)

= Cash flow from Operations (CFO) (164,176)

24
 Dr. Ridha ESGHAIER
The Statement of Cash Flows (year (n))
 L.T INVESTING ACTIVITIES
Investment in Gross fixed assets (1,202,950 - 491,000) 711,950
= Cash from investing (711,950)
 FINANCING ACTIVITIES
Increase in notes payable (636,808 - 200,000) 436,808
Increase in long-term debt (723,432 – 323,432) 400,000
Payment of cash dividend (0.11 x 100,000) (11,000)
= Cash flow from financing 825,808

 NET CHANGE IN CASH (-164,176-711,950+825,808) (50,318)

Cash at beginning of year (year (n-1)) : 57,600

+ Net change in Cash : (50,318)
= Cash at end of year (year (n)) : 7,282
25

Dr. Ridha ESGHAIER

What can you conclude about the firm’s

financial condition from its statement of CFs?

• Net cash from operations = -$164,176,

mainly because of negative Net Income.
• The firm borrowed $825,808 to meet its
cash requirements.
• Even after borrowing, the cash account fell
by $50,318 (Net Change in Cash between year (n-1) & year (n))

26
 Dr. Ridha ESGHAIER

What Can The Statement of Cash Flows

Tell Us?
Here are a few ways the statement of cash flows is used.
• The cash from operating activities is compared to the company's net income.
– If the cash from operating activities is consistently greater than the net
income, the company's net income or earnings are said to be of a "high
quality".
– If the cash from operating activities is less than net income, a red flag is
raised as to why the reported net income is not turning into cash.
• Some investors believe that "cash is king". The cash flow statement identifies
the cash that is flowing in and out of the company. If a company is
consistently generating more cash than it is using, the company will be able to
increase its dividend, buy back some of its stock, reduce debt, or acquire
another company. All of these are perceived to be good for stockholder value.
• A decrease in the net cash account of a company does not always reveal a
bad position of the company if it is due to large investments made by the firm
and if its net cash from operations is positive and relatively high. 27

Interpreting the statement of cash flows

The statement of cash flows is important because it identifies the sources of cash
flowing into the company and shows how they have been used. To get an overall view
of the company, we need to read the statement in conjunction with the other main
financial statements – profit or loss and other comprehensive income and financial
position – and also in the context of the previous year’s statements.
The following points should be borne in mind:
• Like the other financial statements, the statement of cash flows uses the money
measurement concept. This means that only items which can be recorded in money
terms can be included; also we must be aware of the effect of inflation if comparing
one year with the next.
• Look for positive cash flows from the operating activities section. In particular,
look at the subtotal ‘cash (used in)/from operations’ – this shows the cash from
revenue-producing activities before the payment of interest and tax.
• Make a comparison between the amount of profit and the amount of cash generated
from operations. Identify the reasons for major differences between these figures –
look at the changes in inventories, trade and other receivables, and trade and other
payables, and put them into context. For example, it would be a warning sign if
there were large increases in these items in a company with falling profits, and such
a trend would put a strain on the liquidity of the business. Also consider the
company’s policies on collecting trade receivables and potential for bad
(irrecoverable) debts, payment to trade payables (is the company paying too
28
quickly?) and control of inventories (are surpluses building up?).
• Look at the figure for ‘net cash (used in)/from operating activities’, ie the cash from
operations after interest and tax have been paid. If it is a positive figure, it shows that
the company has been able to meet its interest and tax obligations to loan providers
and the tax authorities.
• The investing activities section of the statement shows the amount of investment made
during the year (eg the purchase of non-current assets). In general there should be a
link between the cost of the investment and an increase in loans and/or share capital –
it isn’t usual to finance noncurrent assets from short-term sources, such as a bank
overdraft.
• In the financing activities section of the statement, where there has been an increase in
loans and/or share capital, look to see how the money has been used. Was it to buy
non-current assets or other investments, or to finance inventory and trade receivables,
or other purposes?
• Look at the amount of dividends paid – this is an outflow of cash that will directly
affect the change in the bank balance. As a quick test, the amount of net cash from
operating activities should, in theory, be sufficient to cover dividends paid; if it
doesn’t, then it is likely that the level of dividends will have to be reduced in future
years.
• The statement of cash flows, as a whole, links profit with changes in cash. Both of
these are important: without profits the company cannot generate cash (unless it sells
non-current assets), and without cash it cannot pay bills as they fall due.
29

Dr. Ridha ESGHAIER

Excel Application

Download and open the Excel Files « BS, IS & CF

Statement 1 (Blank) » and « BS, IS & CF Statement 2
(Blank) »
1. Calculate the differences on the balance sheet
2. Calculate net CAPEX using the note below the
cash flow statement
3. Complete the cash flow statement
4. The boxes to complete are in grey

30
 Dr. Ridha ESGHAIER

Part 2. Major Financial

indicators
• Working Capital & Operating Working Capital
• Total Operating capital
• Net CF, Net Operating CF
• Free Cash flow to the Firm (FCFF) &
Free Cash Flow to Equity (FCFE)
• The cash flow identity : Cash flow to creditors
and cash flow to shareholders
• Economic value added (EVA)
• Market value added (MVA)
31

Dr. Ridha ESGHAIER

What are operating

current assets?
 Operating current assets are the Current
Assets needed to support operations.
• Op CA include: Accounts receivable and
inventory
• Op CA exclude: Cash(1), short-term
investments, because these are not a
part of operations.
(1) Oftencash is excluded from Operating current assets because it’s not
necessary in the day-to-day running of a business. However, sometimes it may be
classed as operational if a business requires cash, such as a travel shop for
currency exchange. However, most businesses purchase and sell goods/services
on credit and don’t require cash to generate revenues. 32
 Dr. Ridha ESGHAIER

What are operating

current liabilities?

 Operating current liabilities are the Current

Liabilities resulting as a normal part of
operations.
• Op CL include: accounts payable and accruals.
• Op CL exclude: notes payable (because this is a
source of financing, not a part of operations) or
any other short-term debts that charge interest

33

Dr. Ridha ESGHAIER

Gross Working Capital Vs. Net Working Capital

- Working Capital (Gross)

Working capital is a narrower definition of the resources used in a
firm's operations. Working capital focuses on the day-to-day
operations and, therefore, includes only items such as inventory, cash,
raw materials and accounts receivable. (≈ Current Assets required in
production)
- Net Working Capital
NWC is the difference between Current Assets and Current Liabilities
and measures the firm short-term financial health (the excess of
current assets over the current liabilities).
NWC is also the portion of Current Assets which is financed with LT
funds instead of current liabilities and thus measures the capital
required in the short term to run the business.

34
 Dr. Ridha ESGHAIER

Net Working Capital

Application 3: Compute the Net Working Capital (NWC) of
the firm for each year and the variation in the net working
capital ΔNWC between the 2 years
NWC = Current Assets – Current Liabilities
= (Cash & Eq + [Link] + Inventories )
– ([Link] + Notes Payable + Accruals)

NWCyear (n) = ($7,282 + $632,160 + $1,287,360)

– ($524,160 + $636,808 + $489,600)
= 1,926,802 – 1,650,568 = $276,234
NWCyear (n-1) = ($57,600 + $351,200 + $715,200 )
– ($145,600 +$200,000 + $136,000)
= 1,124,000 – 481,600 = $642,400

ΔNWC = NWCyear (n) – NWCyear (n-1) = $276,234 - $642,400 = -$366,166

35

Net Operating Working Capital

Net operating working capital is a financial metric used to measure
operational liquidity of a business or its operational requirement.
Its measure is based solely on the operating current items of the
balance sheet and is calculated by subtracting all noninterest-bearing
current liabilities from current assets required in production.
Noninterest-bearing current liabilities include accounts payable and
accruals (which are expenses that have accrued but have not been
paid). Current assets required in production are essentially working
capital ( [Link] + Inventories ) .

NOWC = [Link] Assets – [Link] Liabilities

= ([Link] + Inventories ) – ([Link] + Accruals)
NOTE: Often cash is excluded from Operating current assets because it’s
not necessary in the day-to-day running of a business. However, sometimes it
may be classed as operational if a business requires cash, such as a travel shop
for currency exchange. However, most businesses purchase and sell
goods/services on credit and don’t require cash to generate revenues.
Dr. Ridha ESGHAIER 36
 Application 4: What is the Net Operating Working
Capital of the firm for each year and the variation in the net
operating working capital ΔNOWC between the 2 years ?
Operating
NOWC = current – Operating
assets current liabilities

NOWC = ( [Link] + Inventories ) – ([Link] + Accruals)

NOWCyear (n) = ($632,160 + $1,287,360) – ($524,160 + $489,600)

= $905,760 operational requirement of the firm in year (n)
NOWCyear (n-1) = ($351,200 + $715,200 ) – ($145,600 + $136,000)
= $784,800 operational requirement of the firm in year (n-1)

ΔNOWC = NOWCyear (n) – NOWCyear (n-1) = $905,760 – $784,800 = $120,960

(working capital requirement for year n)

Dr. Ridha ESGHAIER 37

Dr. Ridha ESGHAIER

Total Net Operating capital

Operating capital is defined as the total capital used for daily
operations in a business. This definition is broad and includes all
factories, equipment, inventories and raw materials the company
uses in its daily operations.
Total Net operating capital is the sum of all net operating working
capital and net Operating fixed assets. These fixed assets include
plant, land and equipment that are "fixed" in the sense that they are not
easily moved, as opposed to cash and inventory.
Therefore, the basic difference between net operating working capital
and total net operating capital is the items included in these two
measures of capital
Total Net Operating capital = NOWC + Net [Link] Assets

T. Net Operating Capitalyear (n) = $905,760 + $939,790

= $1,845,550
T. Net Operating Capitalyear (n-1) = $784,800 + $344,800
38
= $1,129,600
 Total Net Operating Capital illustration
Assets Liab. & Equity

Op. Current Op. Current

Assets Liabilities
≈ Working Capital

- Acc. Payable
- Acc. Receivable - Accruals
Current - Inventories
Current

Total Net Operating Capital

Assets Net Operating
liabilities Net Operating
Working
Working
Capital
Capital

Cash
S-T invest
Notes Payable +
Net Op.
Net Op. Fixed
Fixed - LT Liabilities Assets
Assets
- Owners Funds

Dr. Ridha ESGHAIER 39

Total Assets Total L. & Eq

Dr. Ridha ESGHAIER

Net Operating Profit After Taxes

(NOPAT)
• If two companies have different amounts of debt, hence different interest
charges, they could have identical operating performances but different
net incomes. The one with more debt would have a lower net income.
• Net income is certainly important, but does not always reflect the true
performance of a company’s operations.
• A better measurement for comparing managers’ performance is net
operating profit after taxes (NOPAT), also called the Unlevered Net
Income, which is the amount of profit a company would generate if it had
no debt and held no nonoperating assets.

NOPAT = EBIT (1 – Tax rate)

NOPATyear (n) = -$130,948 (1 – 0.4) = -$78,569

NOPATyear (n-1) = $190,428 (1 – 0.4) = $114,257 40

 The Cash Flow estimation
• The firm’s cash flow generally differs from its accounting
profit because some of the revenues and expenses listed on
the income statement may not have been received or paid in
cash during the year.
• The relationship between the cash flow and the company’s
income can be expressed as follows:
cash flow = income
– Noncash revenues
+ Noncash charges
• Typically, depreciation and amortization are by far the
largest noncash items, and in many cases the other noncash
items roughly net out to zero. For this reason, many analysts
assume that :
cash flow = income + Dep & Amt
Dr. Ridha ESGHAIER 41

Dr. Ridha ESGHAIER

Net Cash Flow (Net CF)

• The firm’s Net cash flow is its Net income adjusted for the
non-cash revenues and charges.
• The relationship between net cash flow and net income can
be expressed as follows:
Net cash flow = Net income + Dep & Amortization

NCFyear (n) = ($160,176) + $116,960 = -$43,216

NCFyear (n-1) = $87,960 + $18,900 = $106,860

 Dr. Ridha ESGHAIER

Net Operating Cash Flow (Net OCF)

The Net Operating Cash Flow is the cash Flow of the firm if it had No
Debt and No non Operating assets and is measured as follows:

Net OCF = EBIT(1-Tax rate) + Depreciation and

Unlevered Net Income amortization(1)
Net OCF = NOPAT + Depreciation and amortization(1)
(1) From the income statement not from the balance sheet

OCFyear (n) = ($78,569) + $116,960

= $38,391
OCFyear (n-1) = $114,257 + $18,900
= $133,157 43

Dr. Ridha ESGHAIER

Free Cash Flow (FCF)

• Free Cash Flow (FCF) sometimes goes by a different name, Cash flow from
assets. Of course, there is no such thing as “free” cash. Instead the name
refers to cash that the firm is free to distribute to creditors and
stockholders because it is not needed for working capital or fixed asset
investments
• Free cash flow can be splitted into Free cash flow to the firm (FCFF) and
Free Cash Flow to Equity (FCFE). They represent the cash flows available
for distribution to, respectively, all of the investors in the company
(creditors and stockholders) and to common stockholders only.; hence the
Free Cash flow is the basis of the Firm’s Value and the Equity Value.
• It is common in finance to speak of a firm’s free cash flow and a project’s
cash flow (or net cash flow), but these are based on the same concepts. In
fact, a project’s cash flow is identical to the project’s free cash flow, and a
firm’s total net cash flow from all projects is equal to the firm’s free cash
flow.
• In practice, there is some variation in exactly how free cash flow is
computed; different users calculate it in different ways. Nonetheless,
whenever you hear the phrase “free cash flow”, you should understand
that what is being discussed is cash flow from assets or something quite
similar. 44
Dr. Ridha ESGHAIER
FCFF Vs. FCFE
• Free cash flow to the firm is the cash flow available to the
company’s suppliers of capital (include bondholders and common
shareholders plus, occasionally, holders of preferred stock) after all
operating expenses (including taxes) have been paid and necessary
investments in working capital (e.g., inventory) and fixed capital
(e.g., equipment) have been made. FCFF is the cash flow from
operations minus capital expenditures. A company’s suppliers of
capital include common stockholders, bondholders, and
sometimes, preferred stockholders. The equations analysts use to
calculate FCFF depend on the accounting information available.
• Free cash flow to equity is the cash flow available to the
company’s holders of common equity after all operating expenses,
interest, and principal payments have been paid and necessary
investments in working and fixed capital have been made. FCFE is
the cash flow from operations minus capital expenditures minus
payments to (and plus receipts from) debtholders. 45

Dr. Ridha ESGHAIER

FCFF & FCFE vs. NI, CFO, EBIT & EBITDA

• The way in which free cash flow is related to a company’s net
income, cash flow from operations, and measures such as
EBITDA (earnings before interest, taxes, depreciation, and
amortization) is important: The analyst must understand the
relationship between a company’s reported accounting data and
free cash flow in order to forecast free cash flow and its
expected growth. Although a company reports cash flow from
operations (CFO) on the statement of cash flows, CFO is not free
cash flow. Net income and CFO data can be used, however, in
determining a company’s free cash flow.
• The advantage of FCFF and FCFE over other cash-flow concepts
is that they can be used directly in a DCF framework to value
the firm or to value equity. Other cash-flow- or earnings-related
measures, such as CFO, net income, EBIT, and EBITDA, do not
have this property because they either double-count or omit
cash flows in some way. 46
 Computing FCFF & FCFE from Net Income
• We can write the expression for FCFF as follows: Dr. Ridha ESGHAIER
FCFF = Net income available to common shareholders (NI)
Plus: Net noncash charges (NCC) (example: Depreciation & Amortization)
Plus: Interest expense × (1-Tax rate) (1)
Less: Investment in fixed capital (FCInv or Capex) (Gross capital expenditures for
long-term assets, such as the property, plant, and equipment or intangible assets
such as trademarks) FCInv = Capex = Δ [Link] = Δ [Link] + Δ D&A =
Net Fix. Ass (end) – Net [Link] (Beg) + D&A (from I.S)
Less: Investmment in working capital (WCInv)(2) (the net investment in operating
current assets such as accounts receivable, less operating current liabilities, such
as accounts payable.)
This equation can be written more compactly as
FCFF = NI + NCC + Int(1 – Tax rate) (1) – FCInv – WCInv Eq.1
FCFE = NI + NCC – FCInv - WCInv + Net borrowing Eq.2
(1) After- tax interest expense must be added back to net income to arrive at FCFF. This step is required
because interest expense net of the related tax savings was deducted in arriving at net income and because
interest is a cash flow available to one of the company’s capital providers (i.e., the company’s creditors).
Similar to after- tax interest expense, if a company has preferred stock, dividends on that preferred stock are
deducted in arriving at net income available to common shareholders. Because preferred stock dividends are
also a cash flow available to one of the company’s capital providers, this item is added back to net income
available to common shareholders in deriving FCFF.
(2) When finding the net increase in working capital for the purpose of calculating free cash flow, we define
working capital to exclude cash and cash equivalents as well as notes payable and the current portion of
long- term debt. Notes payable and the current portion of long- term debt are excluded because they are
liabilities with explicit interest costs that make them financing items rather than operating items. 47

Dr. Ridha ESGHAIER

Computing FCFE from FCFF

FCFE is cash flow available to equity holders only. To find

FCFE, therefore, we must reduce FCFF by the after- tax
value of interest paid to debtholders and add net
borrowing (which is debt issued less debt repaid over the
period for which one is calculating free cash flow):
Free cash flow to equity = Free cash flow to the firm
Less : Interest expense (1- Tax rate)
Plus : Net borrowing
or
FCFE = FCFF – Int(1 – Tax rate) + Net borrowing Eq.3
48
 Computing FCFF and FCFE from CFOperations
CF from Operations is the net income adjusted for non-cash charges and
variations of working capital items (operating current assets and liabilities)
Since CFO = NI + NCC – WCInv , then from Eq.1,
• Free cash flow to the firm = Cash flow from operations
Plus: Interest expense (1- Tax rate) Dr. Ridha ESGHAIER
Less: Investment in fixed capital
or
FCFF = CFO + Int(1–Tax rate) – FCInv Eq.4
To reiterate, the after-tax interest expense is added back
because it was previously taken out of net income. The
investment in working capital does not appear in this
formula because CFO already includes investment in
working capital.
• Then using FCFE = FCFF – Int(1–Tax rate) + Net borrowing
FCFE = CFO - FCInv + Net borrowing Eq.5 49

Finding FCFF and FCFE from EBIT or EBITDA

• To show the relationship between EBIT and FCFF, we start with
Eq.1 and assume that the only noncash charge (NCC) is
depreciation (Dep): Dr. Ridha ESGHAIER
FCFF = NI + Dep + Int(1 – Tax rate) – FCInv – WCInv
Or NI = (EBIT – Int)(1–Tax rate) = EBIT(1–Tax rate) – Int(1–Tax rate)
Substituting this equation for NI in Eq.1, we have
FCFF = EBIT(1 – Tax rate) + Dep – FCInv – WCInv Eq.6
• The relationship between FCFF and EBITDA can also be easily
shown. Net income can be expressed as :
NI = (EBITDA – Dep – Int)(1 – Tax rate)
= EBITDA(1 – Tax rate) – Dep(1 – Tax rate) – Int(1 – Tax rate)
Substituting this equation for NI in Eq.1 results in
FCFF = EBITDA(1 – Tax rate) + Dep(Tax rate) – FCInv – WCInv Eq.7
• Then FCFE = FCFF – Int(1 – Tax rate) + Net borrowing 50
 More about FCFF from EBIT calculation
• Free Cash flow to the Firm is the amount of cash available from operations for
distribution to all investors (including stockholders and debt holders) after making
the necessary investments (in fixed assets and working capital requirements) to
support operations. Dr. Ridha ESGHAIER

• FCFF involves three components: operating cash flow, capital spending and
change in net working capital.
– Operating cash flow refers to the cash flow that results from the firm’s day-
to-day activities of producing and selling.
– Capital spending refers to the net spending on fixed assets (purchases of fixed
assets less sales of fixed assets)
– change in net working capital is measured as the net change in operating
current assets relative to operating current liabilities for the period being
examined and represents the amount spent on net operating working capital.

 Depr and   Capital 

FCFF = EBIT (1 - T) + – + ∆ NOWC
 amortization expenditures 

FCFF = NOPAT - Net investment in operating capital Eq.8
51

Dr. Ridha ESGHAIER

Calculating FCFF from EBIT

CFF = [ EBIT(1-T) + D&A ] – [ Cap Exp + ΔNOWC ]

= [ NOPAT + D&A ] – [ Δ [Link] + ΔNOWC ]
= [ NOPAT + D&A ] – [ Δ [Link] + Δ D&A + ΔNOWC ]
= NOPAT – [ Δ [Link] + ΔNOWC ]
= NOPAT – Δ Tot net Op Capital
52
= NOPAT – Net Inv in Op Cap Eq.8
 FCFF & FCFE from NI, CFO, EBIT, EBITDA & NOPAT
• FCFF and FCFE are frequently calculated by starting with net income:
FCFF = NI + NCC + Int(1–Tax rate) – FCInv – WCInv Eq.1
FCFE = NI + NCC – FCInv – WCInv + Net borrowing Eq.2
• FCFF and FCFE are related to each other as follows:
FCFE = FCFF – Int(1–Tax rate) + Net borrowing Eq.3
• FCFF and FCFE can be calculated by starting from cash flow from operations:
FCFF = CFO + Int(1–Tax rate) – FCInv Eq.4
FCFE = CFO – FCInv + Net borrowing Eq.5
• FCFF can also be calculated from EBIT or EBITDA:
FCFF = EBIT(1–Tax rate) + Dep – FCInv – WCInv Eq.6
FCFF = EBITDA(1–Tax rate) + Dep(Tax rate) – FCInv – WCInv Eq.7
FCFF = EBITDA – EBIT(Tax rate) – FCInv – WCInv
FCFE can then be found by using FCFE = FCFF – Int(1–Tax rate) + Net borrowing
• FCFF can also be calculated from NOPAT and Net Operating Capital:
FCFF = NOPAT – Net FCInv – WCInv Eq.8
= NOPAT – Net Inv in Operating Capital Dr. Ridha ESGHAIER
53

Dr. Ridha ESGHAIER

Application 5:

Based on the information on pages 5, 6, 9 and 23 and the

calculations made in the previous applications for year (n)
1. Calculate FCFF starting with the net income figure.
2. Calculate FCFE starting from the FCFF calculated in
Part 1.
3. Calculate FCFE starting with the net income figure.
4. Calculate FCFF starting with CFO.
5. Calculate FCFE starting with CFO.
6. Calculate FCFF starting with EBIT.
7. Calculate FCFF starting with EBITDA.
8. Calculate FCFF starting with NOPAT.

54
 Dr. Ridha ESGHAIER
Q1. FCFF starting with NI
FCFF = NI + NCC + Int(1–Tax rate) – FCInv – WCInv Eq.1
= ($160,176) + $116,960 + $136,012(1-0.4) – $711,950 – $120,960
= -$794,518.8
FCInv = The increase in Gross fixed assets shown on the balance sheet and in capital expenditures
shown as an investing activity in the statement of cash flows : $711,950 (1,202,950-491,000)
WCInv = The increase in Operating working capital is $120,960, which is the increase in accounts
receivable of $280,960 (632,160 - 351,200) plus the increase in inventories of $572,160 (1,287,360-
715,200) minus the increase in accounts payable of $378,560 (524,160-145,600) minus the increase in
accrued taxes and expenses of $353,600 (489,600-136,000)

Q2. FCFE starting from the FCFF

FCFE = FCFF – Int(1–Tax rate) + Net borrowing Eq.3
= -$794,518.8 – $136,012(1-0.4) + $836,808 = -$39,318
Net borrowing = New debt issued less debt repaid over the period : variation in notes payable $436,808
(636,808 - 200,000) plus variation in long term debt $400,000 (723,432 – 323,432) = $836,808

Q3. FCFE starting with NI

FCFE = NI + NCC – FCInv – WCInv + Net borrowing Eq.2
= ($160,176) + $116,960 – $711,950 – $120,960 + $836,808 = -$39,318
55

Dr. Ridha ESGHAIER

Q4. FCFF starting with CFO

FCFF = CFO + Int(1–Tax rate) – FCInv Eq.4
= -$164,176 + $136,012(1-0.4) – $711,950
= -$794,518.8

Cash flow from Operations (CFO) = Net income + Depreciation + Increase in Acc. Payable
+ Increase in accruals - Increase in Acc. Receivable - Increase in inventories

Q5. FCFE starting with CFO

FCFE = CFO – FCInv + Net borrowing Eq.5
= -$164,176 – $711,950 + $836,808
= -$39,318

56
 Dr. Ridha ESGHAIER
Q6. FCFF starting with EBIT
FCFF = EBIT(1–Tax rate) + Dep – FCInv – WCInv Eq.6

 Depr and   Capital 

FCFF = EBIT (1 - T) + – + ∆ NOWC
 amortization expenditures 

Operating CF Gross inv. In Op Capital

FCFF (n) = [-$130,948(1 – 0.4) + $116,960]

Operating CF

– [($1,202,950 – $491,000) + ($905,760 – $784,800)]

Gross [Link] ((n) – (n-1)) NOWC ((n) – (n-1))

= $38,391.2 – $711,950 – $120,960 = -$794,518.8

57

Dr. Ridha ESGHAIER

Q7. FCFF starting with EBITDA

FCFF = EBITDA(1–Tax rate) + Dep(Tax rate) – FCInv – WCInv Eq.7

= 13,988(1-0.4) + $116,960(0.4) – $711,950 – $120,960

= -$794,518.8

Q8. FCFF starting with NOPAT

FCFF = NOPAT – Net investment in operating capital Eq.8
FCFF = -$78,568.2 – ($1,845,550 - $1,129,600)
= -$794,518.8 Tot Net Op. Cap ((n) – (n-1))

58
 Dr. Ridha ESGHAIER

What are the five uses of FCFF?

1. Pay interest on debt.

2. Pay back principal on debt.
3. Pay dividends.
4. Buy back stock.
5. Buy nonoperating assets (e.g., marketable
securities, investments in other companies,
etc.)

59

Dr. Ridha ESGHAIER

FCFF and FCFE on a Uses-of- Free- Cash- Flow

Basis
Prior sections illustrated the calculation of FCFF
and FCFE from various income or cash flow
starting points (e.g., net income or cash flow
from operations). Those approaches to
calculating free cash flow can be characterized
as showing the sources of free cash flow. An
alternative perspective examines the uses of
free cash flow.

60
 Uses of FCFF Dr. Ridha ESGHAIER

Uses of FCFF = Increases (or minus decreases) in cash balances

Plus: Cash flow to creditors: Net payments to providers of
debt capital, which are calculated as:
o Plus: Interest expense × (1 – Tax rate).
o Plus: Repayment of principal in excess of new borrowing
(or minus new borrowing in excess of debt repayment if
new borrowing is greater).
Plus: Cash flow to stockholders: Payments to providers of
equity capital, which are calculated as:
o Plus: Cash dividends.
o Plus: Share repurchases in excess of share issuance (or
minus new share issuance in excess of share repurchases
if share issuance is greater).
Uses of FCFF must equal sources of FCFF
61

Dr. Ridha ESGHAIER

Uses of FCFE
Free cash flows to equity reflect free cash flows to the firm
net of the cash used for payments to providers of debt
capital. Accordingly, we can calculate FCFE as follows:
Uses of FCFE = Increases (or minus decreases) in cash
balances
Plus: Payments to providers of equity capital, which are
calculated as:
o Plus: Cash dividends.
o Plus: Share repurchases in excess of share issuance (or
minus new share issuance in excess of share
repurchases if share issuance is greater).
Again, the uses of FCFE must equal the sources of FCFE
62
 Dr. Ridha ESGHAIER

The Cash flow identity

• From the balance sheet identity, we know that the
value of a firm’s assets is equal to the value of its
liabilities plus the value of its equity. Similarly, the cash
flow from the firm’s assets must equal the sum of the
cash flow to creditors and the cash flow to stockholders
(or owners):
Free Cash flow to the Firm = Variation in Cash balance
+ Cash flow to creditors
+ Cash flow to stockholders
• This is the cash flow identity. It says that the free cash
flow to the firm is equal to the variation in cash plus
the cash flow paid to suppliers of capital to the firm. 63

Cash flow to creditors

and Cash flow to stockholders

The cash flows to creditors and stockholders

represent the net payments to creditors and
owners during the year.
– Cash flow to creditors is after tax interest paid
less net new borrowing;
– cash flow to stockholders is dividends paid less
net new equity raised.

Dr. Ridha ESGHAIER

64
 Application 6: Using data from application 1, compute
the firm’s variation in cash balance, Cash flow to
creditors and Cash flow to stockholders for year (n).
Check the cash flow identity. Dr. Ridha ESGHAIER

• Cash flow To Creditors :

Looking at the income statement, we see that the company paid $136,960 in interest
to creditors. From the balance sheets, we see that Notes payable and long-term debt
rose by $836,808. So the company paid out $136,960 in interest, but it borrowed an
additional $836,808. Thus,
Cash flow to creditors = interest paid (1-tax rate) – Net new borrowing
= 136,012 (1 – 40%) – 836,808 = – $755,200.8
• Cash flow To Stockholders :
From the “other data” table, we see that dividends paid to stockholders amounted to
$0.11 x 100,000 = $11,000. To get net new equity raised, we need to look at the
common stock account. This account tells us how much stock the company has
sold. During the year, this account remained unchanged ($460,000), so $0 in net
new equity was raised. Given this, we have the following:

Cash flow to stockholders = Dividends paid – Net new equity raised

= 11,000 – 0 = $11,000 65

The Cash flow identity

• Variation in Cash Balance:

Looking at the Balance sheet, we see that the company’s variation in cash balance is
: $7,282 - $57,600 = -$50,318 (same from the bottom of the cash flow statement)
The last thing we need to do is to verify that the cash flow identity holds to be sure we
didn’t make any mistakes.
From the Application 5, we know that free cash flow to the firm is :
FCFF = – $794,518.8.

Variation in cash balance plus cash flow to creditors and stockholders is :

Variation in Cash balance + Cash flow to creditors + Cash flow to stockholders

= – $50,318 – $755,200.8 + $11,000 = – $794,518.8

so everything checks out.

Dr. Ridha ESGHAIER

66
 Dr. Ridha ESGHAIER

Is negative Free Cash Flow to the Firm

always a bad sign?

• It is important to note that negative free cash

flow to the firm is not bad in itself.
• If free cash flow to the firm is negative, it could be
a sign that a company is making large
investments. If these investments earn a high
return, the strategy has the potential to pay off in
the long run.
• A negative FCFF is a bad sign if the Operating
Profit is negative too.
67

Dr. Ridha ESGHAIER

Excel Application

Download and open the Excel File « FCFF

Calculation & CF Statement (Blank) »

Complete the boxes in gray and Calculate the

FCFF from NI, From EBIT and from EBITDA

68
 Dr. Ridha ESGHAIER

Market Value Added

(MVA)
• The accounting statements do not reflect market values,
so they are not sufficient for purposes of evaluating
managers’ performance. To help fill this void, financial
analysts have developed two additional performance
measures, the first of which is the Market Value Added
(MVA).
• MVA is simply the difference between the market value of
a firm’s equity and the book value as shown on the
balance sheet, with market value found by multiplying
the stock price by the number of shares outstanding.
MVA = Market value __ Book value
of equity of equity
69

Dr. Ridha ESGHAIER

Application 7: What is the firm’s MVA?

MVA shows the difference between the market value of a
company’s Equity and its book value.
MVA = [Stock Price x Nber of outst. Shares] – Book value of equity

MVAyear (n) =100,000 x $2.25 – $492,592

= -$267,592
MVAyear (n-1) = 100,000 x $8.5 – $663,768
= $168,232
The higher the MVA, the better. A high MVA indicates the company has
created substantial wealth for the shareholders.

70
 Dr. Ridha ESGHAIER

Economic value added (EVA)

• In corporate finance, Economic Value Added or EVA, is an
estimate of a firm's true economic profit for a given year.
• Quite simply, EVA is the profit earned by the firm less the cost of financing
the firm's capital (which includes both the cost of Equity and Debt )

EVA = NOPAT – Annual dollar cost of capital

• In order to generate positive EVA, a firm has to more than just cover
operating costs. It must also provide a fair return to those who have
provided the firm with capital.
• if EVA is positive, then after-tax operating profit exceeds the cost of the
capital needed to produce that income, and management’s actions are
adding value for stockholders.
• Whereas MVA measures the effects of managerial actions since the very
inception of a company, Economic Value Added (EVA) focuses on
managerial effectiveness in a given year.

71

Dr. Ridha ESGHAIER

EVA
• Economic Value Added measures the extent to which the firm has
increased shareholder value.
• Economic Value Added is an estimate of a business’s true economic
profit for the year, and it differs sharply from accounting profit
• EVA represents the residual income that remains after the cost of all
capital, including equity capital, has been deducted
• As we discuss in Chapter 9, equity capital has a cost because
shareholders give up the opportunity to invest and earn returns
elsewhere when they provide capital to the firm. This cost is an
opportunity cost rather than an accounting cost, but it is quite real
nevertheless.
• Note that when calculating EVA we do not add back depreciation.
Although it is not a cash expense, depreciation is a cost because
worn-out assets must be replaced, and it is therefore deducted when
determining both net income and EVA
72
 Dr. Ridha ESGHAIER
Application 8: What is the firm’s EVA? Assume the
firm’s after-tax percentage cost of capital was 10% in year (n-1)
and 13% in year (n).
EVA = NOPAT – (A-T %cost of capital)x(Total Net [Link])

With Total Net Operating Capital = NOWC + Net [Link] Assets

EVAyear (n) = -$78,569 – (0.13)x($1,845,550)

= -$78,569 – $239,921.50 = -$318,490.50
EVAyear (n-1) = $114,257 – (0.10)($1,129,600)
= $114,257 – $112,960 = $1,297

• EVA represents the residual income that remains after the cost of all
capital, including equity capital, has been deducted,
• whereas accounting profit (net income) is determined without
imposing a charge for equity capital.
73

Dr. Ridha ESGHAIER

Comments about EVA and MVA

We will have more to say about both MVA and EVA in the next chapter, but we
can close this section with two observations.
• First, there is a relationship between MVA and EVA, but it is not a direct
one. If a company has a history of negative EVAs, then its MVA will probably
be negative; conversely, its MVA probably will be positive if the company
has a history of positive EVAs. However, the stock price, which is the key
ingredient in the MVA calculation, depends more on expected future
performance than on historical performance. Therefore, a company with a
history of negative EVAs could have a positive MVA, provided investors
expect a turnaround in the future.
• The second observation is that when EVAs or MVAs are used to evaluate
managerial performance as part of an incentive compensation program,
EVA is the measure that is typically used. The reasons are:
(1) EVA shows the value added during a given year, whereas MVA
reflects performance over the company’s entire life, perhaps even including
times before the current managers were born;
(2) EVA can be applied to individual divisions or other units of a large
corporation, whereas MVA must be applied to the entire corporation. 74
 Dr. Ridha ESGHAIER

Application 9:
Last year a company had $6 million in operating income (EBIT). It had a net
depreciation expense of $1.5 million and an interest expense of $1 million; its
corporate tax rate was 40%. The company has $13 million in operating current
assets and $5 million in operating current liabilities; it has $16 million in net
plant and equipment. It estimates that it has an after-tax cost of capital of 10%.
Assume that the company’s only noncash item was depreciation.
a. What was the company’s net income for the year?
b. What was the company’s net operating profit after taxes (NOPAT)?
c. Calculate net operating working capital of the current year
d. Compute the total net operating capital for the current year
e. If total net operating capital in the previous year was $22 million, what was
the company’s free cash flow (FCFF) for the year?
f. What was the company’s Economic Value Added (EVA)?

75

Dr. Ridha ESGHAIER

Solution app.9
a. EBIT $6,000,000
- Interest $1,000,000
= EBT $5,000,000
- Taxes (40%) $2,000,000
= Net income $3,000,000
b. NOPAT =EBIT (1− T)
= 6,000,000 (1-0.4) = $3,600,000
c. NOWC = Operating cur. assets − Operating cur. liabilities
= ( [Link] + Inventory) − ([Link] + Accruals)
= $13,000,000 − $5,000,000 = $8,000,000

76
 Dr. Ridha ESGHAIER

d. Total Net Operating Capital = NOWC + Operating Fixed Assets

= $8,000,000 + $16,000,000 = $24,000,000

e. FCFF = NOPAT − Net investment in operating capital

= $3,600,000 – ($24,000,000 – $22,000,000)
= $1,600,000

f. EVA = EBIT (1−T) – (Total capital x After-tax cost of capital)

= $6,000,000 (1-0.4) – ($24,000,000 x 0.1)
= $3,600,000 - $2,400,000 = $1,200,000

77

Dr. Ridha ESGHAIER

Application 10:
Consider the following balance sheet and income statment

Balance Sheet
Assets Liabiities & Owners' Equity
2016 2017 2016 2017
Current Assets Current Liabilities
Cash $104 159,84 Accounts Payable $232 $266
Accounts Receivable 455 688 Notes Payable 196 123
Inventory 553 555 Total $428 $389
Total $1 112 1 402,84
Fixed Assets
Net Fixed assets $1 644 $1 709 Long-term debt $408 $454
Owners' equity
Common stock and
paid-in surplus 600 640,00
Retained earnings 1 320 1628,84
Total $1 920 2268,84
Total Liabilties &
Total assets $2 756 3 111,84 Owners Equity $2 756 3111,84

78
 Dr. Ridha ESGHAIER

Income Statement
Net sales $1 509
Cost of goods sold 750
Depreciation 65
Earnings before interest and taxes $694
Interest Paid 70
EBT $624
Taxes (34% of EBT) 212,16
Net Income 411,84
Dividends $103
Addition to retained earnings 308,84

Compute the company’s:

- Free Cash Flow to the Firm
- Cash flow to creditors
- Cash flow to Shareholders
Check the CF identity

79

Solution app.10 Dr. Ridha ESGHAIER

FCFF = EBIT(1-T) + Dep – FCInv – WCInv Eq.6

Since in the provided balance sheet the Fixed capital is in net amounts not in
gross amounts :
FCInv = ΔNet fixed assets + Depreciation (from income statement)
= ending net FA– beginning net FA + depreciation
= $1709 – $1644 + $65 = $65 + $65 = $130
WCInv = ΔNOWC = ending NOWC – beginning NOWC
= ($688 + $555 – $266) – ($455 +$553 – $232) = $201
FCFF = EBIT(1-T) + Dep – FCInv – WCInv
= $694(1-0.34) + $65 – $130 – $201 = $192.04
Or use FCFF = NOPAT – Net FCInv – WCInv Eq.8
= $694(1-0.34) – $65 – $201 = $192.04

• CF to Creditors = interest paid (1-tax rate) – net new borrowing

= $70(1-0.34) – [($454 +$123) – ($408+$196)] = $73.2
• CF to Shareholders = dividends paid – net new equity
= $103 – ($640 – 600) = $63
• Variation in cash balance = ending cash – beginning cash =159.84 – 104 = $55.84
FCFF = Δ Cash + CF to creditors + CF to stockholders = 55.84 + 73.2 + 63 = $192.04
80
Dr. Ridha ESGHAIER

Application 11:
Consider the following information
Income Statement
Net sales $ 600
Cost of goods sold $ 300
Depreciation $ 150
EBIT $ 150
Interest paid $ 30
EBT (34%) $ 120
Taxes $ 41
Net income $ 79

Dividends $ 40
Addtion to retained earnings $ 39

Other Data year n year n-1

Op Current Assets $2 260,0 $2,130
Op Current Liabilities $1 710,0 $1,620
Net Fixed Assets $750 $500
Cash 15 3
81

Dr. Ridha ESGHAIER

1. Compute the company’s FCFF
2. suppose we know that the company didn’t sell any new equity for the year.
What was its cash flow to stockholders? Its CF to creditors? its Net new borrowing?

Solution app.11
FCFF = EBIT(1-T) + Dep – FCInv – WCInv
= Operating cash flow – Net capital spending
– Change in operating working capital

Operating Cash Flow

EBIT $ 150
EBITxT $ 51
+ Depreciation $ 150
$ 249

82
 Net Capital Spending
Ending Net Fixed Assets $ 750
- Beginning Net Fixed Assets $ 500
+ Depreciation $ 150
$ 400

Change in Operating Working Capital

(year n) Op. Current Assets $ 2 260,0
(year n) - Op Current Liabilities $ 1 710,0
(year n) Net Op Working Capital $ 550
(year n-1) Op. Current Assets $ 2 130,0
(year n-1) - Op Current Liabilities $ 1 620,0
(year n-1) Net Op Working Capital $ 510
Change in Net Op Working Capital $ 40

Free Cash Flow to the Firm

Operating Cash Flow $ 249
- Net Capital Spending $ 400
- Change in Net Op Working Capital $ 40
$ (191)
83
Dr. Ridha ESGHAIER

Cash flow to stockholders = Dividends paid – Net new equity raised

 Because the company didn’t raise any new equity, its cash flow to
stockholders is just equal to the cash dividend paid ($40)
 Now, from the cash flow identity, we know that the total cash paid to creditors
and stockholders plus the variation in cash balance were -$191. Cash flow to
stockholders is $40, variation in cash balance is $12 ($15 – $3) so cash flow to
creditors must be equal to -$191 – $12 – $40 = -$243
 Because we know that cash flow to creditors is -$243 and interest paid x(1-T) is
$20: $30(1-0,34) (from the income statement), we can now determine net new
borrowing. The company must have borrowed $263 during the year to help
finance the fixed asset expansion
Cash Flow to Creditors ?
FCFF $ (191)
= Variation cash balance $ 12
+ CF to stockholders $ 40
+ CF to creditors ??? $ (243)

Cash Flow to Creditors =

Interest Paid (1-T) $ 20
- Net New Borrowing ??? $ (263)
$ (243) 84
Dr. Ridha ESGHAIER
 Useful Visual Tools
• Cumulative cashflow curves
Calculating a Cumulative Cash Flow Curve

• Investor expectation on return drive evaluations

[Link]
prod/interactives/085_investor_expectations/[Link]

• Asset intensity ratios

[Link]
prod/interactives/081_asset_intensity_ratio/[Link]

85