Homework and Assigned Reading
Security Analysis (FIN 40610)
Professor Zambrana
Lecture 4 – DCF Valuation: Cash Flows
Lecture 4 discusses inputs for discounted cash flow (DCF) valuation models. This lecture will focus on
the adjustments and calculations necessary to move from earnings to cash flows, both for historical
and forecasted financial statements. This will include discussions of how to deal with specific items
such as one-time charges, R&D expenses, operating lease expenses, and acquisition costs, as well as
measuring and interpreting capital expenditures and working capital requirements.
After completing this material, we will focus on calculating the terminal value and the final steps
required in a DCF valuation model in Lecture 5. We will also analyze the firm fundamentals that drive
growth in earnings and cash flows.
Homework:
Complete the homework problems on the attached pages and submit your solutions in a PDF file by
the assigned due date. Be prepared to discuss your solutions in class.
Required and Related Reading:
The table below describes the required reading from the McKinsey book. I recommend reviewing all
end-of-chapter review questions associated with the required McKinsey readings. You should focus on
the topics covered in class and your course notes in both the readings and review questions.
For those who want to gain a deeper knowledge of valuation, I have listed additional related readings
from the McKinsey and Damodaran books.
Required Reading:
Book Chapter Topic
McKinsey Ch. 10 Framework for Valuation
McKinsey Ch. 11 Reorganizing the Financial Statements
McKinsey Ch. 22 Leases
Optional Related Reading:
Book Chapter Topic
McKinsey Ch. 20 Taxes
McKinsey Ch. 21 Non-operating Items, Provisions, and Reserves
McKinsey Ch. 23 Retirement Obligations
McKinsey Ch. 24 Measuring Performance in Capital-Light Businesses
Damodaran Ch. 9 Estimating Earnings
Damodaran Ch. 10 From Earnings to Cash Flows
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Problem Set #4
1. You are valuing a firm that makes significant use of acquisitions. The most recent income statement
for this firm is provided below. In addition, the firm has an effective tax rate of 20% and a marginal
tax rate of 40%. Use the information below and incorporate all necessary adjustments that we
discussed in class to calculate
A. The adjusted value of operating income that should be used as a starting point for FCFF
B. The adjusted value of Net Income that should be used as a starting point for FCFE
Income Statement
Revenues $6,075
COGS $1,832
Selling & Admin. $1,215
Expenses
Restructuring Charges $902
Goodwill Amortization $185
In-Process R&D Charge $65
EBIT $1,876
Investment Income $67
Interest Expense $91
Taxable Income $1,852
Taxes $370
Net Income $1,482
Q1A:
Restructuring Charges: 902
Goodwill Amortization: 185
In-Process R&D Charge: 65
These are non-recurring expenses, so we add them back to EBIT:
Adjusted EBIT=1,876+902+185+65=3,028
Adjusted Operating Income for FCFF= 3,028×(1−0.20)=2,422.4
Q1B:
Investment Income: 67
Adjusted Net Income for FCFE=1,482−67(1-0.2) =1,494.4
= 1428
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2. You are performing a valuation of Zara. Based on Zara’s future operating lease
commitments, you estimate that the firm’s operating lease debt is $2,648 million, and you
assume a depreciable life of 10 years on the operating lease assets. Zara’s reported
operating income equals $590 million. In addition, the firm has an operating lease expense
of $410 million and a cost of debt equal to 3%. The firm’s effective and marginal tax rates
are both 40%. Calculate the firm’s adjusted value of after-tax operating income after
accounting for operating lease debt.
Deprecation= 2684/10 = 268.4
590(1-0.4)+(410-268.4) * (1-0.4) = 438.96
3. You are valuing Biogen and have decided to capitalize the firm’s R&D expenses over a 10-year life.
Biogen’s operating income in the most recent year was $5,329 million, and R&D expenses in the
most recent year were $2,800 million. Using the firm’s history of R&D expenses, you estimate that
the current year’s R&D amortization is $1,931 million, and the unamortized value of R&D
remaining at the end of the year is $12,000 million. The effective and marginal tax rates are both
equal to 36%. The firm also has CapEx of $1,730 million, depreciation of $1,280 million, and an
increase in non-cash working capital of $320 million. Using this information, calculate the value of
FCFF for this firm before and after adjusting for the capitalization of R&D. Does the R&D adjustment
impact the value of FCFF?
FCFF for this firm before adjusting for the capitalization of R&D:
1. Calculate After-Tax Operating Income:
After-Tax Operating Income=5,329×(1−0.36)= 3,410.56
2. Add Back Depreciation:
Adjusted Operating Income=3,410.56+1,280= 4,690.56
3. Subtract Capital Expenditures:
Adjusted Operating Income=4,690.56−1,730= 2,960.56
4. Change in working capital:
Adjusted Operating Income=2,960.56-320= 2640.56
FCFF for this firm before adjusting for the capitalization of R&D = 2640.56
FCFF for this firm after adjusting for the capitalization of R&D:
Adjusted after tax Operating Income=5,329+2,800−1,931=6,198 million
FCFF after adjusting R&D = 6198+1280- 1730-320= 5419
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4. For our in-class example of Home Depot, we assumed the effective and marginal tax rates for Home
Depot equal 23.6%. That assumption produces an enterprise value of $281,960.6m (based on
standard discounting). Suppose the tax law is changed following the election to increase the federal
corporate tax rate to its former level (36.6%).
A. If in 2019, Home Depot had adjusted operating income of $16,085m, Net CapEx of $236m, and
a change in Working Capital of $533m, calculate the impact of this tax change by recalculating
Home Depot’s FCFF in 2019.
B. What impact would this have on the enterprise value of Home Depot (in comparison to the value
using the tax rate of 23.6%) if you assume a WACC of 7.4% and you assume the firm’s cash flows
grow a rate of 4% for five years followed by a stable rate of 3% forever?
Q4A:
FCFF(36.6% rate) = 16058(1-0.366)- 236-533
= 9428.89
FCFF(23.6% rate) = 16058(1-0.236)- 236-533
= 11519.94
FCFF for the new rate is lower by (11519.49-9428.89) = 2091.05
Q4B:
Year FCFF PV
1 9806.0456 $9,130.40
2 10198.2874 $8,841.35
3 10606.2189 $8,561.46
4 11030.4677 $8,290.43
5 11471.6864 $8,027.97
TV 11815.837 $187,927.53
Total $230,779.13
With the increased tax rate, the enterprise value of Home Depot is approximately $230,779.13, which is
lower than the previous enterprise value calculated at $281,960.6
5. You are analyzing non-cash working capital for a firm that reports current assets & liabilities, as
shown below (in millions). The firm’s revenues in the most recent year were $35,600 million, and
you assume it requires operating cash equal to 2% of sales to run its day-to-day operations.
Calculate the value of non-cash working capital for this firm.
Current Assets Current Liabilities
Cash and Short-term Investments 1,200 Short-term Debt 1,200
Inventory 2,530 Accounts Payable 2,530
Pre-paid Operating Expenses 320 Wages Payable 1,560
Accounts Receivable 1,860 Operating Expenses Payable 775
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Deferred Tax Assets 855 Current Portion of Long-term Debt 855
Total Current Assets 6,765 Total Current Liabilities 6,920
Non-cash Current asset = 6765 – 1200 = 5565
Non-Debt Current Liabilities = 6920 – 1200 – 855 = 4865
Non-cash working capital = 5565 – 4865
= 700
6. Which of the following statements is INCORRECT?
A. Non-operating assets include excess cash, investments, overfunded pension programs, and
unutilized real estate.
B. Non-operating liabilities include things like underfunded pension programs and legal liability.
C. Cash flow from investments accounts for capital expenditures, investments in other firms, and
other investing activities.
D. Cash flow from financing activities accounts for capital raised and payouts to stockholders
and bondholders.
E. None of the above.
7. Which of the following statements is INCORRECT?
A. Net Income measures accounting earnings rather than actual cash flow.
B. EBITDA does not account for changes in working capital or capex.
C. Cash flow from operations is the net income adjusted for non-cash revenues & expenses and
changes in working capital items.
D. FCFF measures the cash flow available to equity investors after accounting for non-cash
revenues & expenses, taxes, changes in working capital, and Capex.
E. None of the above.
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8. Which of the following statements is INCORRECT?
A. Goodwill is an intangible asset representing the amount paid in an acquisition over the fair
value of the company’s net assets.
B. Goodwill impairment occurs when the value of that goodwill declines below what is recorded
on the balance sheet.
C. Goodwill impairment and in-process R&D charges are cash expenses, so we should analyze
earnings after subtracting these charges.
D. In-process R&D refers to unfinished R&D projects a company acquires during a business
purchase.
E. None of the above
9. Which of the following statements is INCORRECT?
A. If we do not account for operating leases, we have an incomplete understanding of both the
firm’s leverage and its investment in operating assets.
B. The operating leasing adjustment does not directly impact net income since it is net of both
operating and financing expenses.
C. For valuation purposes, increases in operating lease assets should be treated as additional
capital expenditures.
D. Operating lease adjustments lead to an increase in debt ratios used in the cost of capital
calculation.
E. None of the above
10. Which of the following statements is INCORRECT?
A. To better understand a firm’s investment in operating assets, we should treat R&D as a capital
expenditure that results in an intangible asset.
B. If we ignore R&D expenses in our valuation, we will have an incomplete understanding of the
firm’s reinvestment for future growth and an incorrect value for the firm’s equity.
C. When capitalizing R&D, operating and net income will generally decrease for firms with
growing R&D expenses.
D. If R&D expenses are flat, earnings will not be affected since the amortization will offset the
R&D expense added back.
E. None of the above
