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FINANCIAL ANALYSIS AND

DECISION MAKING:
HANDBOOK & TEMPLATES













Neil G. Cohen, DBA, CFA
School of Business
The George Washington University
Washington, DC USA

ngcohen@gwu.edu







! 2013 Neil G. Cohen. All rights reserved.
2 July 2013

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TABLE OF CONTENTS
CHAPTER 1 - USING FINANCIAL STATEMENTS INTELLIGENTLY
The Close Relationship between Finance and Accounting: The IS/BS Model "
Structure and Terminology Issues #$
Reliability of Financial Statements Bogus or Accurate? #%
CHAPTER 2 - FINANCIAL STATEMENT ANALYSIS WITH RATIOS
Purpose of Financial Ratios ! Diagnostic Metrics &#
Taxonomy of Financial Ratios &#
The DuPont Formula &'
Ratio Interpretation Template &(
Operating Leverage and Breakeven Levels &%
CHAPTER 3 - FORECASTING FINANCIAL STATEMENTS &
DETERMINING EXTERNAL FINANCING NEEDED
Percentage-of-Sales Forecasting of Financial Statements & Determining External Financing Needed ))
The Short-Form Forecasting Model ))
Interpreting External Financing Needed ''
CHAPTER 4 - FINANCIAL ARITHMETIC THE TIME VALUE OF MONEY
Basics of Time Value of Money '%
Tables for Compounding & Discounting ")
Automating the Calculations Using HandyCalc "*
CHAPTER 5 - CAPITAL BUDGETING & COST OF CAPITAL
Overview of Capital Budgeting $#
Calculate the Discount Rate Weighted Average Cost of Capital (k
wacc
) (+
Calculate Decision Criteria: Net Present Value, Profitability Index, Internal Rate of Return, Payback Period (%
CHAPTER 6 - EQUITY VALUATION
The Basics *(
Dividend Discount Model (DDM) %*
Free Cash Flow Equity Valuation (FCF) Model %%
Market Multiples Equity Valuation Model #+&
Nine Elements in the Equity Valuation Process A Summary #+$
CHAPTER 7 - DEBT VS. EQUITY FINANCING
& LEASE VS. BORROW-TO-BUY ANALYSIS
The Debt vs. Equity Decision #+(
The Lease vs. Borrow-to-Buy Decision #&#

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The image on the book cover depicts five key concepts in financial decision-making:



Return and Risk, always considered together, refer to the duality at the root of
finance theory, where return is a rate of return on investment and risk is the
variability over time in that rate of return.
Growth is the objective of (most) businesses, to grow revenues, profits, and the
value of the business.
Sustainability refers to the hope that growth in revenues, profits, and stock price
will continue into the future.
Cash Is King! (the kings crown) refers to the maxim that if its not cash money
(the stack of money), its not real. The accountants measurement of net income
and retained earnings do not represent money that can be spent (the cigar box,
where the money is kept in a small business); only cash can be spent.



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CHAPTER 1
USING FINANCIAL STATEMENTS INTELLIGENTLY

The Close Relationship between Finance and Accounting: The IS/BS Model

Introduction

Learning Objectives
1. Understand the layout and terminology of an income statement
2. Understand the layout and terminology of a balance sheet
3. Understand the layout and terminology of a cash flow statement
4. Understand the link between the income statement and balance sheet
5. Understand why Cash is King!

Accounting is a Foreign Language

This is a discussion about linguistics you are learning a foreign language with all the
challenges that involves: irregularities, too many synonyms and code switching, which
to a linguist, is changing from one language to another in the same sentence or
paragraph. Accountants and financial analysts dont make it easy for users of financial
statements, with so many different terms and formats for presenting financial
statements. This makes it frustrating for learners. Relax about it; as in language learning,
practice and repetition is the key. You will get better at it as you go along. Its a skill, and
building a skill takes time.

Cash Basis versus Accrual Accounting

Accrual accounting records all transactions, whether or not cash has changed hands. For
example, if you pay employees every two weeks, the salary due them accrues day-by-day
on your books as a current liability you owe to them. Similarly, if you obtained inventory on
credit, then sell it to your own customer before you pay your supplier for it, the cost of the
goods sold includes the cost of those items.

Cash basis means that transactions are recorded only when cash changes hands:
merchandise is sold for cash or an employee's salary is paid in cash. This means that when
merchandise is sold on credit, or when raw materials are bought from suppliers on credit,
no record of the transaction goes into the company's books if the cash basis is used.
Accordingly, an income statement drawn at any given time, under the cash basis, will not
reflect all of the business's transactions, and may provide a misleading picture of business
performance.

Under accrual accounting, such transactions must be included, as they should be, because
they are costs of doing business. Under the cash basis, they would be excluded,
understating the cost of doing business and overstating income tax and profit. Some
businesses, especially those dealing in services rather than products and where cash is
paid, can operate on the cash basis without great danger of having distorted financial
statements. It is required under the accounting law, however, that most businesses use
accrual accounting. This accounting method matches sales revenue against those

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expenses incurred which generated the revenue for the accounting period, whether or not
cash has changed hands.

The IS/BS Model



Financial statements describe the operations of a business - the scorecard for the
business. Shown above is a summary diagram of the Income Statement/Balance Sheet
accounting model of the business - organizing financial data so the performance of the
business can be measured and controlled. The accounting model consists of the income
statement, the balance sheet, and the cash flow statement, each of which is discussed in
the material that follows. The information in financial statements is summarized with
financial ratios, the subject of Chapter 2. Dont worry about that now. Gain a solid
understanding of the financial statement terminology and structure first things first!

View the balance sheet as a snapshot of a business, freezing action at a moment in time. It
lists the dollar amount in each asset, liability, and equity account. In contrast, view the
income statement as a moving picture summarizing the flow of revenues and expenses
during the period of time. Where the balance sheet is written as of an ending date (the
moment in time), the income statement is written to cover a period of time (month, quarter,
year). The balance sheet and the income statement are linked when the profit retained in
the business, shown on the final line of the income statement, is added to the equity section
of the balance sheet, increasing the owners investment in the business, or decreasing it if
there is a loss.



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Balance Sheet is a SNAPSHOT of account balances FROZEN at a POINT in time

Income Statement is a MOVING PICTURE of transactions FLOWING over a
PERIOD of time


ASSETS = LIABILITIES + EQUITY

COMMON EQUITY =
COMMON STOCK + RETAINED EARNINGS

The universal accounting equation is shown in the box above: Assets equal liabilities plus
equity. Look at the income statement/balance sheet model and relate what you see in the
box, the accounting equation, to the structure of the financial statements depicted in the
model. Since the last line on the income statement summarizes the results of running the
business during a period of time.sales revenue minus expenses minus taxes minus
dividends equals profit reinvested in the business.that profit reinvested is transferred into
the equity account on the balance sheet. The balance sheet then portrays the position of
the business at a moment in time at the end of the accounting period.

An accountant is obligated to prepare financial statements that truly and fairly portray the
results of business operations, following accounting principals and the law. No matter what
country is involved, these are the fundamental principles:
the business is assumed to be a going concern
completeness
truth
clarity of presentation
consistency with prior year
agreement with closing balance sheet of previous year
accrual accounting with matching of revenue and expenses
prudence
disclosures
individual valuation of assets and liabilities
inter period allocation of income and expense

You will soon realize that formats and terminology for financial statements vary widely. To
keep the focus clear and unambiguous, the formats used throughout this book are a

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composite of illustrative financial statements from United States Generally Accepted
Accounting Principles (USGAAP), International Accounting Standards (IAS), and
International Financial Reporting Standards (IFRS)
1
. This approach minimizes confusion
for those who are learning about financial statements for the first time. As your skills
develop and your understanding deepens, you will be able to work with any format and
terminology that comes your way, because USGAAP, IAS, and IFRS are variations on the
same theme.

Layout and Terminology of the Income Statement


Revenue is also called sales, net sales, or turnover in some countries.
Cost of sales, sometimes called cost of goods sold (CGS), is the cost to the
business of either buying and/or producing the goods/services it sells. It
includes wages, cost of operating a factory, depreciation, and other direct and
indirect production costs. Cost of sales is a combination of fixed and variable
costs.
Sales minus cost of sales equals gross profit, also called gross margin. It
represents the amount remaining to cover general overhead expenses after
deducting the cost of making or buying the goods that are sold.

1
A concise, clearly written article on IFRS is Illustrative Financial Statements Presentation and
Disclosure Checklist: International Financial Reporting Standard for Small and Medium-Sized
Entities. Find it on this website:
http://www.ifrs.org/IFRS+for+SMEs/IFRS+for+SMEs+and+related+material.htm

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Distribution costs, sometimes called selling costs, are those connected with
sales and marketing activity.
Administrative costs are the general overhead of the business. Research and
development expense can be included here or given a separate account title of
its own. Although distinctions between fixed cost and variable cost are rarely
found in published financial statements, you can think of distribution costs as
more variable than administrative costs although both categories include both
fixed and variable components.
Depreciation and amortization expense recognizes the usage of fixed assets
such as buildings (but not land, which is not depreciated), machines, and
equipment. Many income statements do not show depreciation expense as a
separate item. Instead, it is included as part of cost of sales, distribution costs,
administrative costs, etc. Remember that depreciation is a non-cash charge. An
expense such as paying salary to workers means that cash is paid out a cash
charge. Depreciation is a non-cash charge because no cash is paid out. It is an
expense that recognizes the use of previously purchased fixed assets.
Depreciation and amortization expense is linked to the balance sheet when the
annual expense is added to the account for accumulated depreciation and
amortization on the balance sheet. For example, an asset is purchased for
$1,000 to be depreciated over 10 years. Each year there is $100 depreciation
expense on the income statement. After the first year, the fixed asset is booked
at $900, the $1,000 purchase price minus $100 depreciation for the first year.
After ten years, the fixed asset will be valued at $0 because $100 of
depreciation for each of 10 years accumulates to $1,000.
Other operating costs is a catch-all account for other items
Restructuring costs will be zero unless these non-recurring costs occur.
Profit from operations is gross profit less all operating expenses. This account
is also called earnings before interest and taxes (EBIT). It is also called
operating profit, and is sometimes it is called trading profit.
Interest, financing expense is interest paid on borrowed money.
Income from investments is non-operating income
Disposal of operations will be zero unless these non-recurring costs occur.
Profit before tax is the sum of operating profit or loss, financial profit or loss,
and extraordinary items.
Income tax is income tax.
Profit after tax is profit before tax minus income tax. This is the so-called
bottom line of an income statement, the figure showing how well the business
has performed during the accounting period.
Minority interest, other provides a place to enter these special categories, if
relevant.
Dividends means cash dividends paid to owners
Other is a catch-all category
Reinvested in the business also called increase in retained earnings, which
is transferred to the balance sheet to show the increase (or decrease if a loss
occurs) in the stockholders equity from the current periods activity.


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Layout and Terminology of the Balance Sheet







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Assets are listed in order of liquidity (that is, the ease with which the asset can be converted
into cash). Liabilities are listed according to the priority claims of creditors. Equity is the
difference between assets and liabilities; it represents the book value of the owner's equity
in the business. It is called book value because it is the amount on the books. It has little or
nothing to do with the market value of the business, as you will see later in the course.
Equity is considered a residual because it is the amount remaining after what is owed
(liabilities) is subtracted from what is owned (assets).

Current assets:
Cash & equivalents includes the cash in the till, cash in the bank, and highly liquid,
high quality securities with short maturities
Investments are liquid investments, usually securities
Trade receivable, also called accounts receivable, is the total amount of money
owed to your company by the customers who have purchased goods or services on
credit. The credit terms may be very short, such as 15 days, or very long, up to one
year. If you know from past experience that a certain percentage of these accounts,
say 2%, will never be collected, the accounts receivable entry should be net of the
estimate of uncollectible accounts. Deduct an estimate of bad debts to get net
accounts receivable.
Inventory means goods available for sale to customers, and includes all costs
involved in producing or obtaining them. In manufacturing, it is divided into three
categories: raw materials, work-in-progress, and finished goods. Include only goods
available for sale; office supplies, spare parts for production equipment, and
gasoline for delivery trucks may not be classified as inventory items.
Other current assets is a catchall category.

Non-current assets, also called fixed assets:
Property, plant and equipment-gross are assets with useful lives in excess of
one year. Note that land is not depreciated it does not wear out or get used up.
Accumulated depreciation and amortization is the aggregate, cumulative
depreciation and amortization expense from all income statements, year-by-year.
Property, plant, and equipment-net is property, plant and equipment less
accumulated depreciation and amortization.
Investment property is ambiguous and depends on the situation, likely to be an
ownership interest in another business
Goodwill is the excess of market value paid over book value in an acquisition. It
may also include intangibles such as intellectual property or trademarks.
Other is a catchall category.

Current liabilities:
Trade and other payables, also called accounts payable, is the amount of
money owed to suppliers for goods or services bought on credit. The credit terms
can be very short, say 10 days, or up to one year, and still be considered a current
liability. This account is vendor financing.
Retirement benefit obligation is pension payments due to retired employees
within one year.
Tax liabilities, also called income tax payable or accrued taxes, is the income
tax due to governments within one year.
Leases due in 1 year is short-term lease payments due
Loan, debt due in 1 year is the principal amount of borrowings due in one year.

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Other is a catchall category.

Non-current liabilities, sometimes called long-term debt:
Retirement benefit obligation is aggregate pension payments due to retired
employees.
Deferred tax liabilities are the reconciling entry between the income tax calculated
on GAAP taxable income and the income tax calculated on the income tax return.
An alternative definition is the difference between taxes due and taxes paid under
different accounting regimes, such as accelerated depreciation used on the tax
return and straight-line depreciation used on GAAP financial statements.
Finance leases due after 1 year is the present value of future lease payments.
Loans, debts due after 1 year is the principal amounts of borrowings.
Other is a catchall category.

Shareholders equity (Net worth):
Preferred stock is the par value of preferred shares outstanding.
Common stock is the par value of shares issued to shareholders.
Additional paid-in capital is the difference between the amount the investor
paid for shares issued and the par value of the shares when the shares were
issued. In modern accounting, common stock and paid-in-capital can be
summed, to represent the money paid by owners when the shares were issued
to them.
Other is a catchall category.
Retained earnings is accumulated profit (loss) since the business started. It is
increased (decreased) each year when profits reinvested in the business (from
the income statement) are added to the previous balance of accumulated profits
on the balance sheet. (Treasury stock is a deduction for common stock
repurchased by the corporation. It is a misnomer because stock repurchase
reduces shares outstanding repurchased shares no longer exist after they are
repurchased they are cancelled - therefore, treasury stock does not exist and
does not appear as an entry on this balance sheet.
Total equity (also called net worth) is the sum of preferred stock, common
stock, additional paid-in-capital, other, and retained earnings
Minority interest is a catchall category.

The Link between Income Statement and Balance Sheet

The above sections discussed the income statement and the balance sheet independently.
From now on, the two financial statements will be discussed as a set, because one cannot
be interpreted without the other. From our discussion of income statements, you should
remember that the bottom line is profit after tax minus dividends: profit reinvested in the
business. This is the result of the moving picture of business operations for the year (or
quarter or month). How do the results of the moving picture get into the snapshot shown by
the balance sheet? The answer is simple: profit (loss) reinvested in the business, shown at
the bottom of the income statement, is added to the accumulated profit (loss) on the
balance sheet.


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Keep in mind that :
income statement reinvested profit is for only one period of time the period for that
particular income statement only.
reinvested profit on the balance sheet is the accumulation of all reinvested profits
from all the income statements since the business began.

Similarly, keep in mind that:
depreciation and amortization expense on the income statement is for that period
only.
accumulated depreciation and amortization on the balance sheet is the cumulative
depreciation expense from all the income statements.
Learn not to confuse depreciation expense (income statement) with accumulated
depreciation (balance sheet). Eventually, accumulated depreciation reduces the book value
of an asset to zero; signifying that is has been fully depreciated.

Profit versus Cash

Profit after tax is not the same as cash (unless cash basis accounting is used). Profit is a
measurement of revenue minus expenses minus tax transactions, as defined by GAAP
rules for accrual accounting, whether or not cash changes hands. As actual cash is
collected, some goes to pay expenses, some goes to increase assets, some goes to pay
liabilities, and some goes to pay dividends. A growing business almost always spends
more cash than it receives, using external funds to close the gap. Therefore, please, never
confuse cash with profit - they are not the same. A business with large and growing profit
often has a cash deficit until it raises money from debt or equity financing. Material
presented in subsequent weeks will emphasize why CASH IS KING. Cash is money. A firm
can have positive net profit yet still go out of business because of a lack of cash .A
business can invest money in working capital and fixed assets, or use the money to repay
debt and give dividends to shareholders. Profit and retained earnings are creatures of
accounting methods, not money. Lots of effort will be made during the weeks that follow to
clarify this notion further. It is one of your key learning objectives - you cant afford to
misunderstand it.

Layout and Terminology of the Cash Flow Statement

Cash flow statements are also called:
Statement of sources and uses of funds
Statement of sources and application of funds
Statement of funds flows
Statement of changes in financial position
Funds statement

Although there are variations in the layouts of cash flow statements, all of them are used as
a bridge between the income statement and the balance sheet, for the purpose of tracing
how funds were used and where those funds came from. A cash flow statement shown on
the following page is derived from the income statement and balance sheet it is not a
unique statement. It rearranges the income statement and balance sheet data.


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Classification of Sources and Uses of Funds

The table below shows a simple summary for understanding the difference between a
source and a use of funds.

The cash flow statement summarizes the where got-where gone situation sources and
uses of funds. It is divided into three categories, operating activities, investing activities, and
financing activities. The sum of cash inflows and outflows is the annual increase or
decrease in cash. That figure, adjusted for the effect of foreign exchange rate changes and
the cash balance at the beginning of the year, gives the cash balance at the end of the
year.

Operating activities are income statement flows. GAAP requires interest paid to
be entered in this category, even though it seems more like an investment activity.
Net cash provided by operating activities is sometimes abbreviated CFFO, Cash
Flow From Operations.
Investing activities represent increases or decreases in balance sheet asset
accounts.
Financing activities are increases or decreases in balance sheet liability or equity
accounts adjusted by Dividends from the income statement.

Know the three parts of the Cash Flow Statement, as it is shown above, know that it is
derived from the income statement and balance sheet and is not a unique statement, and
know the source/use definitions in the table above. Your primary effort should be placed on
the income statement and balance sheet.

Summary

You must know, intimately, the format and terminology of income statements and
balance sheets, however boring it may seem at this early point in the course. These
statements are the way we portray the companies we are talking about.

Above all, you must appreciate that net income on the income statement does not
represent cash. It sounds silly to say it, but, only cash (on the balance sheet) is cash. It
is the only money you can spend. You cant spend profit and you cant spend retained
earnings. They may be accounting accruals, creations of accounting rules, but they are
not cash. Thats why we say Cash is King! There will be a lot more said about this as
the course rolls on.

ASSET LIABILITY + EQUITY
increases in these accounts increases in these accounts
are USES of funds are SOURCES of funds
decreases in these accounts decreases in these accounts
are SOURCES of funds are USES of funds

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Structure and Terminology Issues

Learning Objectives
1. Realize that financial statements are presented in many variations with no
standard format
2. Realize that terminology of financial statements in full of synonyms and
ambiguity
3. Learn to look for the context of the financial statements and interpret the
details accordingly

Be Aware of Multiple Layouts for Financial Statements

You might expect published financial statements to follow a rigid layout where all income
statements and balance sheets have the same format, with the same titles presented in the
same order. Although accounting standards specify a detailed order of presentation and set
of account titles, considerable variations from this layout are found in practice. You should
not be bothered by variations from the system of accounts presented in the accounting
standard. What you need to know is the logic of how the financial statements are organized
and how they fit together, and to be flexible enough to interpret the context of what is
presented. Its frustrating for the learner, I know, but it will become clear once you reach a
critical mass of knowledge.

Be Aware of Different Words Used to Name the Same Account Titles

Account names in financial statements can have more than one name, causing confusion
when you look at statements from different companies in different countries. You must be
aware of the synonyms because they occur so often. For example, profit after tax can also
be called either after tax profit, net profit, earnings after tax, or net incomeall synonyms.
You must be aware of the synonyms because they occur so often. For example, profit after
tax can also be called either after tax profit, net profit, earnings after tax, or net incomeall
synonyms. You must be aware of the synonyms because they occur so often.

We dont know if authors use terminology shifts on purpose to test your ability to be flexible,
or if they are merely being careless. There is no nationwide or worldwide organization that
decrees standard terminology. Normally, you can determine the meaning of an
unfamiliar term from the context. Alternatively, use the list of synonyms.

Listed below are groups of synonyms for terms that are used interchangeably, categorized
as:
income statement
balance sheet
other


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Income statement (profit and loss statement):

Revenue
Sales
Turnover

Gross profit (money terms)
Gross margin (percentage)
Contribution margin

Operating profit
Earnings before interest and taxes (EBIT)
Trading profit

Pre-tax profit
Profit before tax
Earnings before tax
Income before tax

After-tax profit
Profit after tax
Earnings after tax
Net income
Net profit

Balance sheet (position statement):

Return on equity (ROE)
Return on shareholders investment
Return to owners

Share capital
Common shares
Common stock
Invested capital

Paid-in capital
Stated value
Additional paid-in value
Excess over par

Accumulated surplus
Retained earnings
Reinvested profit
Earned surplus
Balance sheet profit


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Other:

Leverage
Financial Leverage
Gearing

Capital budgeting
Investment decision
Cost-benefit analysis
Project analysis

Summary

This discussion made you aware of the too-numerous synonyms involved in financial
statement terminology. We might wish for more consistency, but know that we wont get
it, and must be ready to deal with financial statements as we find them. As you gain
experience as a user of financial statements, familiarity with the context will permit you to
interpret them properly in spite of terminology and format shifts.



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Reliability of Financial Statements Bogus or Accurate?

Learning Objectives
1. Understand purpose of financial statements
2. Understand why many financial statements are bogus

Is the Measuring Device Rigid or Elastic?

Now that you have begun to master the terminology and structure of financial
statements, do a reality check about the usefulness of this information.


First off, think about this metal ruler. One inch is always one-inch long. The aluminum
does not stretch or shrink. It always stays the same. The user of the ruler relies that the
measuring device is consistent.

Second off, think of the elastic band in these sweat pants. The tag inside says the size is
34, but you can stretch them to a 38 at least, or you can shrink them to maybe a 32 or
30.



20


Are the accounting principles that lie behind financial statements more like the aluminum
ruler or the sweat pants waistband? We might like it better if the answer was ruler but
that is the wrong answer. At their best, financial statements are put together using
rules with lots of flexibility. If this shocks you, give it some thought. You dont want to be
an overly trusting and nave user of financial statements.

Accounting fraud is vigorously prosecuted all over the world. Huge fines are paid. Huge
out-of-court settlements are paid by offending accounting firms when users financial
statements successfully claim that they relied on those statements and were materially
misled. Jail terms for perpetrators of accounting fraud are not unusual. Although the link
below is about the law in the United States, it is included for your reference:

http://www.sarbanes-oxley-forum.com/

Summary

Published financial statements are not what they seem. Dont be reticent about taking
them with a grain of salt. Even in the absence of covert fraud, there is a lot of bogus
information in financial statements. Its healthy to view them as instruments used by
corporations to put their best foot forward.

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CHAPTER 2
FINANCIAL STATEMENT ANALYSIS WITH RATIOS

Financial ratio analysis summarizes the data from the income statement and balance sheet
so you can measure the performance of a business. Also, ratios are the basis for making
forecasts of future operations.

Learning Objectives
1. Interpret a financial statement using financial ratios
2. Understand the difference between comparisons of historical trends within a
company and comparisons of ratios between companies
3. Understand the power of the DuPont formula
4. Understand the limitations of financial ratio analysis
5. Perform financial ratio analysis in an Excel spreadsheet


Purpose of Financial Ratios - Diagnostic Metrics

Think of financial ratios as measures of the relative health or sickness of a business. Just
as a physician takes readings of a patient's temperature, blood pressure, heart rate, and
blood count, a manager takes readings of a firm's liquidity, leverage, efficiency, profitability,
and growth. Where the physician compares the readings to generally accepted guidelines
such as a temperature of 98.6 degrees as normal, the manager uses
trends over time within the company
comparisons to peer companies and industry benchmarks.

By itself, a financial ratio means little. Its meaning comes from making the proper
comparisons.

As you look at the discussion below, keep track of where the input figures for the ratios
come from. Some ratios are made up of income statement figures, some are made up of
balance sheet figures, and others use figures from both income statement and balance
sheet. The RATIO INTERPRETATION template lists each ratio by name, and also shows
its numerator and denominator, a useful display to help you remember the ratios and see
their sources.

In interpreting a ratio, remember that it results from many inputs. You may not be able to
say that the ratio is bad, for example, solely because the numerator is too high. Instead, the
problem may be that the denominator is the cause of the problem rather than the
numerator. Be careful about jumping to conclusions before you examine all of the inputs
making up the ratio.


Taxonomy of Financial Ratios

The ratios are listed in these categories:
Liquidity
Leverage
Efficiency/Asset-Use

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Profitability
DuPont Formula a summary model including three of the above ratios, leverage,
efficiency, and profitability (but not liquidity) multiplied together resulting in return on
equity
Growth rates

Liquidity Ratios

Liquidity ratios measure the ability of the company to pay its bills. A liquid asset is one that
can be converted to cash quickly without suffering a loss of value. Remember that assets
are listed in the balance sheet in increasing order of relative liquidity. Keep in mind that
current assets are uses of funds increasing them means increased investment in the
business, and vice versa. Similarly, current liabilities are sources of funds, such as supplier
creditincreases provide more available funds to invest in the business.
The current ratio compares current assets to current liabilities to show by how
much current assets (cash plus accounts receivable plus inventories) exceeds
current liabilities (bills that must be paid relatively soon). A lower current ratio
means that you are in a riskier position, because fewer liquid assets will be there to
cover current debts. A high ratio means greater liquidity. But a high ratio may also
mean that you have too much invested in current assets. Remember, finance
involves trade-offs. You may sleep better at night knowing that the current ratio is
high and you are in not danger of becoming insolvent (running out of liquid assets
so bills cannot be paid). The other side of the issue is that excessive investment in
current assets reduces your rate of return, because more assets mean greater
investment, the denominator in the rate of return calculation.
The quick ratio, sometimes called the acid-test ratio, is similar to the current ratio.
The difference is that inventory, the least liquid current asset, is deducted from the
numerator of the fraction, because inventory can be liquidated less quickly than
cash or accounts receivable.
Days sales in receivables, also called collection period, measured in number of
days, shows how long it takes to collect from customers who get credit. The smaller
the number of days, the more efficient the collections, and the less money must be
invested in offering credit to customers. If customers demand relaxed credit terms,
keeping receivables too low may reduce sales. The numerator of the fraction is net
receivables (after deducting uncollectible accounts). The denominator is sales
divided by 365, which gives sales per day.
Days cost of goods sold in inventory shows how many days of production (or
purchases from vendors) is invested in inventory. The smaller the number of days,
the better, because it means less money invested in inventory. The risk of stock-
outs must be considered; if inventory is too low, sales might fall when orders cant
be filled. Another way to measure the same thing is inventory turnover. It shows
how many times inventory is sold (turns over) each year, a measure of inventory
efficiency. The higher the ratio the better, because it implies a smaller inventory for
the level of sales, and a smaller inventory means that less money is invested in the
business, raising rate of return. A ratio that is too low might imply the risk of running
out of inventory and losing sales. A ratio measured in days, like days cost of goods
sold in inventory, is easy to interpret because 45 days vs. 90 days is easily
interpreted.
Days cost of sales in payables, also called payment period, measured in
number of days, shows how long it takes to pay suppliers who offer credit. The
smaller the number of days, the quicker the suppliers are getting paid. The

23
numerator of the fraction is net payables. The denominator is cost of sales divided
by 365, which gives cost of sales per day.

Leverage Ratios

Leverage ratios measure the use of borrowed money. They are measures of financial risk,
which means the likelihood of insolvency or bankruptcy if you are unable to pay debts such
as interest payments and repayment of loan principal. High leverage ratios are not
automatically considered bad but should be interpreted as indications that the manager
decided to use debt aggressively. The hope is to grow faster or increase profits by putting
borrowed money to work. This is a reasonable goal. Understand that such a strategy
involves risk. You must consider the risk-return trade-off in deciding how much debt is
acceptable.
Long-term debt to total capital compares the sum of long-term liabilities in the
numerator to the sum of long-term liabilities plus equity in the denominator. The
higher the ratio, the greater the use of borrowing, and the greater the financial risk.
IAS requires that financial leases be included in long-term liabilities.
Long-term debt to equity is the ratio of permanent debt financing to the funds
supplied by owners. Remember that the funds supplied by owners, equity, includes
money paid for shares when it was issued combined with all accumulated profits
reinvested in the business during its entire history.
Times interest earned (coverage ratio) indicates how easy or how hard it is to
cover fixed interest payments on borrowed money. The numerator of the fraction is
the funds available to pay interest, what remains after all operating expenses are
deducted from revenue, i.e., EBIT. The denominator of the fraction is interest that
must be paid. Think of it as the number of times the funds available for interest
payments cover the interest that must be paid. The higher the coverage ratio, the
safer, the greater the cushion available if EBIT falls.
Full burden coverage restates the times interest earned ratio to include lease
payments. Times interest earned considers only the interest expense part of
borrowing. Full burden treats leases as fixed expenses just like debt, providing a
more comprehensive indicator about whether operating profit is sufficient to service
both leases and debt.
Efficiency/Asset-Use Ratios

The purpose of your business is to generate revenue and profits. Therefore, you invest in
assets to create the business and produce the product or service you sell. So you want to
measure how good you are at using assets to generate revenue, hence the efficiency
ratios.
Fixed asset turnover measures the efficiency of fixed assets in generating
revenue. This is a turnover ratio, so a higher result is a good result.
Total asset turnover measures the overall asset efficiency.

Profitability Ratios

Profitability ratios measure profit in relation to the income statement and balance sheet.
Gross margin measures how much of each euro of revenue is left after cost of
goods sold is deducted. It is a measure of how much is left to pay other expenses
after the cost of making or buying the goods is deducted, before consideration of
other operating expenses.

24
Operating profit margin measures what is left after all operating expenses are
deducted from the revenue figure.
Return on sales (ROS) compares profit after tax to sales. It shows how much of
each euro of sales is left after all expenses, including income taxes, are paid. It
does not consider repayment of debt principal, which is not an expense
Return on assets (ROA) compares profit after tax to total assets.
Return on equity (ROE) compares profit after tax to the funds supplied by owners,
equity. This may be the most important number from the viewpoint of the owner,
because it measures the rate of return on the money invested in the business.
Return on invested capital (ROIC) compares EBIT after tax to the assets used to
generate sales. Where ROS and ROA are dependent on and biased by the extent
of debt financing used, because the numerator is profit after tax, ROIC is a
performance metric independent of financing, because its numerator is after tax
EBIT no interest expense is considered in the calculation as it is in ROS and
ROA.

In the table below, Company A has earnings after tax (net income) of $18 with a ROE
of 18%, while Company B has 4 times the earnings after tax but a ROE of 7.2%, less
than one-half that of Company A. The bottom three lines of the example show three
rate of return metrics. Company Bs are all the same because it has no debt (financial
leverage). The ROIC measure removes the impact of the financial policy differences
an important lesson.


The DuPont Formula

The DuPont formula is a powerful diagnostic tool because it decomposes Return on Equity
(ROE) into three components. It is a concise and focused look at how profitability, leverage,
and efficiency combine to determine the return on equity (ROE) of a business. The three
terms are multiplicative, their product being ROE. The terms are:

1. Profitability = Net Income Sales
2. Efficiency = Sales Total Assets
3. Leverage = Total Assets Shareholders equity, generating #4:
4. Return on Equity (ROE) = Net Income Equity

25

The DuPont formula explained above describes a three-component approach. The
following describes a five-component approach that decomposes the profitability ratio into
interest burden and tax burden so these two additional components can be examined
separately.
1. Operating Profit Margin = EBIT Sales
2. Interest Burden = Before Tax Profit Net Income
3. Tax Burden = Net Income Before Tax Profit
4. Leverage = Total Assets Equity
5. Efficiency = Sales Total Assets, generating #6:
6. Return on Equity = Net Income Equity

Growth Rates

Growth rates provide percentage figures to measure growth over time in sales, expenses,
profits, assets, or any other entry on the financial statements. Each is the percentage
change from one year to the next. It is useful to compare growth rates of one account over
different periods, and to compare growth rates for several accounts for the same time
period, to uncover the relative changes.

Warnings in Using Financial Ratios

Warning signs are always posted when financial ratio analysis is underway. Several of the
warnings follow. Please keep them in mind, because the quality of the conclusions you
draw from a ratio analysis is important. They may be the basis of significant business
decisions.
Comparisons are relative. Understand the reasons behind changes in the trend of
a ratio. Economic causes or industry causes may be the driving force rather than
causes within your company. Do not get caught in the trap of thinking that
differences in absolute dollar amounts are always significant ones. Be aware of the
difference between relative comparisons and absolute comparisons, hence the
year-to-year percentage changes shown the table above.
Seasonal trends must be identified to avoid misinterpretation of the ratios. Some
ratios will rise and fall during the year, as a result of seasonal influences that repeat
year after year. Therefore, a change in a ratio from one quarter of the year to the
next may be normal.
Compare ratios using common time periods. Avoid comparing ratios using annual
data to those using quarterly or semiannual data, unless adjustments are made.
When significant changes in the underlying economic, industry, or company
relationships have taken place during the periods of comparison, be extremely wary
about drawing conclusions that will be used to plan for the future.
When earnings per share figures are calculated and compared, you must
remember to make adjustments for changes in the number of shares issued
and outstanding from year to year (the number of shares changes when new
shares are issued or repurchased, or when a split occurs). The denominator of the
earnings-per-share calculation for all periods must contain the number of shares
outstanding for the most recent time period. Unless the calculation is made using
this number, the earnings-per-share data will be useless.
The list of ratios for liquidity, leverage, efficiency, and profitability includes 16 ratios.
What happens if many of them show adverse changes from year to year? Be aware

26
that only one weak factor could be the driving force behind every weak ratio, so
be careful about considering driving factors and resulting factors. For example, a
business with too much borrowing will have too much interest, so all debt ratios will
be weak all caused by the same thing. In the DuPont formula, if both efficiency
and profitability are constant, and debt is rising, ROE will rise, which should not be
interpreted as a strength, but a weakness.
If the increase in debt is caused by strongly growing revenue, is it a bad thing
or a good thing? It may be either a matter of context provided by other
information. These relationships are circular. It is dangerous to consider ratios as
independent factors.
Ratios often pose questions for further investigation rather than giving you the
answer to questions. It is often necessary to look back at the numbers in the income
statement and the balance sheet to properly interpret the result.

27
Ratio Interpretation Template
(best viewed at 175% magnification or see Template Set.xls)

First, look only at the DuPont Formula ratios Table in rows 121-125. You see the
decomposition of ROE, which more-than-tripled from 6.8% to 21.3%. Profitability went up,
about three times. Efficiency went up 21%, and leverage went down 19% (reducing
leverage is good from a default risk standpoint, but bad from a ROE standpoint because
lower profitability means lower ROE). The ROE check is performed in the spreadsheet by
computing ROE directly as NP/E, rather than multiplying the three components together, to
verify the calculation in row 121. The trend column is the rate of change from 2009 to 2010,
showing the relative change for each component. The 216% change in profitability is the
key driver of the 212% change in ROE.

Conclusions from the financial ratio analysis of Universal Industries are:
The large 212% increase in ROE, as discussed above, caused by very large 212%
increase in profitability, helped by a smaller but still impressive 21% change in
efficiency, hurt a little by a 19% decline in leverage is impressive but not likely to be
sustainable.
Profitability increase is powered by operating cost decreases shown in rows 114-15
and reduction of interest expense because of lower debt, confirmed. Unless
sustainable, which is unlikely, profit growth may normalize in the future. Growth in
revenue in row 128 is lower than growth in profits in rows 129-130, confirming the
suspicion that profitability gains are driven by cost reduction rather than either unit
volume or unit price increases.
Big improvements in times interest earned and full burden coverage ratios may lead
to a higher credit-quality rating and a reduction in interest expense.
The liquidity situation is mixed; both days in receivables and inventory have
improved (fewer days), but days in payables are higher. Collection of receivables
may be more efficient and inventory control may be better, but, finance managers
may view these metrics differently than production, marketing, and sales managers.
More days in payables may mean that Universal is taking better advantage of
vendor financing, but, it may be missing discounts for quick payment.
95
96
97
98
99
100
101
102
103
104
105
106
107
108
109
110
111
112
113
114
115
116
117
118
119
120
121
122
123
124
125
126
127
128
129
130
131
A B C D E F G H
YEAR 2010 2011 TREND PRELIMINARY INTERPRETATION NUMERATOR DEMONINATOR
Liquidity Ratios
Current ratio 1.6 1.3 -21% negative, less liquidity current assets current liabilities
Quick ratio 1.1 0.8 -21% negative, less liquidity curr assets-inventory current liabilities
Days sales in receivables 75.4 56.3 -25% positive, quicker collections receivables revenue/365 days
Days cost of sales in inventory 59.9 54.0 -10% positive, faster turnover inventory cost of sales/365 days
Days cost of sales in payables 47.6 65.0 37% negative, paying more slowly payables cost of sales/365 days

Leverage Ratios
Long-term debt to total capital 57.9% 45.5% -21% positive, less financial risk l-t leases+loans+debt l-t leases+loans+debt+equity
Long-term debt to equity 137.4% 83.5% -39% positive, less financial risk l-t leases+loans+debt equity
Times interest earned 1.8 3.8 109% positive, better coverage operating profit (EBIT) finance costs
Full burden coverage 1.5 3.1 107% positive, better coverage oper profit + lease exp finance costs + (lease exp/[1-tax rate])

Efficiency (Asset-Use) Ratios
Fixed asset turnover 1.2 1.4 19% positive, faster turnover revenue total non-current assets
Total asset turnover 0.8 1.0 21% positive, faster turnover revenue total assets

Profitability Ratios
Gross margin 23.9% 34.9% 46% positive, big improvement gross profit revenue
Operating profit margin 6.8% 11.3% 65% positive, bigger improvement operating profit (EBIT) revenue
Return on sales 2.7% 8.6% 216% positive, still bigger improvement net profit revenue
Return on total assets(ROA) 2.2% 8.5% 283% positive, still bigger improvement net profit total assets
Return on equity (ROE) 6.8% 21.2% 212% positive, big improvement net profit equity
Return on invested capital (ROIC) 4.7% 9.4% 100% positive, big improvement EBIT*I1-tax rate) total assets

DuPont Formula - ROE 6.8% 21.3% 212% profitability x efficiency x leverage
Profitability 2.7% 8.6% 216% positive, big improvement net profit revenue
Efficiency 0.8 1.0 21% positive, better turnover revenue total assets
Leverage 3.1 2.5 -19% positive, less financial risk total assets equity
ROE Check 6.8% 21.2% 212% calculation check to verify row 121 net profit equity
Compound Annual Growth Rates
Revenues 40.8% 2010 - 2009 2009
Gross profit 105.7% 2010 - 2009 2009
Operating profit (EBIT) 131.9% 2010 - 2009 2009
Total assets 16.0% 2010 - 2009 2009

28

Summary

You probably expect these financial ratios to give you answers about financial
performance of businesses, but they may pose more questions than answers. It takes
lots of practice and seasoning to work comfortably with them.

A quick ratio analysis can be performed by with the DuPont Formula, then adding in the
Coverage ratio.
The question always comes up, do I need to memorize these ratios? Can I use a cheat
sheet? Sure you can use a cheat sheet. But the more you rely on a cheat sheet, the less
you know, the more you're going to struggle. You'll see that these ratios come up over
and over again. So knowledge of what the terms mean, where the ratio comes from
(income statement or balance sheet), if the ratio is made up of numerator or
denominator only from the income statement or only from the balance sheet, or one from
income statement and one from balance sheet, you should be getting used to all of that.
Your color-coded IS/BS Model always guides you in seeing the source of each
numerator and each denominator.
Notice the three categories for decision-making listed in the IS/BS Model, upper-
right corner:
WORKING CAPITAL
changes spontaneously with revenue
?what levels of ca, cl, s-t loans?
CAPITAL BUDGETING
?which projects to accept?
FINANCING
?how much debt capacity?
Your study of financial ratios should have given you insights into the following questions:
What about WORKING CAPITAL POLICY?
Is each account trending up or down over time?
Is each account tracking with the industry benchmark, or is it higher or lower?
What about Fixed Assets (the result of CAPITAL BUDGETING POLICY)?
Is turnover rising or falling over time?
Is turnover tracking with the industry benchmark, or is it higher or lower?
Is there an indication about full or partial use of plant capacity, i.e., efficiency?
Can a measure of high or low operating leverage (risk) be discerned?
What about FINANCING POLICY?
Is interest coverage rising or falling over time?
Is interest coverage tracking with the industry benchmark, or it is higher or lower?
Is debt capacity being used lightly or heavily?
Can a measure of high or low financial leverage be discerned?


29

Operating Leverage and Breakeven Levels
Breakeven Analysis and Operating Leverage

Published financial statements do not help us very much if we want to distinguish
between fixed and variable costs. Nevertheless, such knowledge, if we had it, would be
important. You do have fixed and variable cost breakdowns for your own business, so
this lesson tells you how important it is and what you need to know about it.

Learning Objectives
1. Understand behavior of variable costs and fixed costs
2. Understand the double-edged sword of operating leverage
3. Understand difference between operating leverage and financial leverage
Breakeven Analysis
You may want to know, for each year of a business plan, what minimum level of revenue is
needed to cover the costs of doing business. In other words, the break-even level of
revenue is where you have zero before tax profit, but where all operating and financial
expenses are covered. A complete discussion of break-even levels requires understanding
of the behavior of fixed costs and variable costs. Some of the expense items listed on the
income statement are fixed, that is, they stay at the same level no matter what the revenue
is. An example of a fixed cost is rent. When the doors are open for business, rent does not
rise or fall as revenue rises or falls. In contrast, other expense items on the income
statement are variable costs, that is, they vary up and down as revenue volume varies up
and down. An example of that is electricity used to power production machines. Be aware
that even fixed costs are variable over the long run, such as an increase in rent when you
move to a larger building.

Breakeven Chart

Below is the classic breakeven chart, plotting revenue against fixed cost, variable cost, and
total cost. Where the revenue line intersects with the total cost line, profit is zero, defining
the breakeven level of revenue.



30

Notice that
the fixed cost line steps up, indicating that growth in the business leads to
increased overhead
the variable cost line starts at zero
the total costs line sums variable and fixed cost, and starts at the minimum level
of fixed cost
the revenue line starts at zero and is steeper than the cost lines
breakeven is defined as zero profit, where revenue equals total cost

Breakeven Point
Revenue
Cost Profit
Total Cost
Loss
Variable Cost
Fixed Cost
Volume (Units)

31
Fixed vs. variable costs

Look at the income statement. Think about the nature of each of these categories. Ask
yourself: To what extent are these costs fixed? In the long run, all costs are variable
because even salaried employees can be fired, leases can be broken, buildings can be
sold, and factories can be expanded. Legacy companies such as airlines use bankruptcy
law to reduce fixed cost by rescheduling debt service payments, revising contractual terms
of leases, rewriting collective bargaining agreements covering wages, health care, and
pensions.

For cost of goods sold, part of it is fixed and part variable. Only knowledge of the specifics
behind a particular business will provide an estimate of the breakdown. Foremen's salaries,
a portion of assembly-line laborers' salaries, a portion of plant maintenance cost, and a
portion of the heat and light bill can all be considered fixed costs. No matter what
fluctuations occur in revenue, the business will continue to operate, and expenses will be
incurred. The portion of cost of goods sold that is not fixed is variable. That means the
materials used in the production process, the electricity used by the machines, and the
workers' salaries that are directly related to the volume of production are variable.

General overhead is partly fixed and partly variable. Any personnel subject to layoff
constitute variable costs, but there are limits to laying off experienced personnel who may
not be available for rehiring when business picks up. It may be short-sighted to attempt to
convert fixed costs into variable costs during temporary periods of slow business, because
gearing back to full production may cost more than was saved, or may be hampered by not
being able to rehire qualified personnel. For example, firing people will cost you in terms of
reputation (people will be less willing to work for you and may demand greater
compensation to do so), retraining costs and overall morale.

Fixed cost, variable cost, and risk

It can be said that high fixed-cost businesses are more risky than low fixed cost
businesses. With high fixed costs, it is easier for a decline in revenue to result in a loss,
because fixed costs must be paid even when revenue drops. A business with low fixed
costs, however, can suffer a much larger drop in revenue before a loss occurs, because as
its revenue fall, most of the costs of operating fall along with them. Therefore, keep in mind
the magnification effect behind the relationship of fixed costs to total costs.






32
The box below demonstrates operating leverage. Company A has $200 of fixed costs. As
its revenue doubles from one year to the next, its operating profit triples. Company B has
no fixed costs, only variable costs. As its revenue doubles from one year to the next, its
operating profit doubles the same proportion as the revenue increase. In contrast,
Company A had a magnified increase in its operating profit, tripling when revenue doubled.
This is how operating leverage works. The presence of fixed costs causes a magnified
change in operating profit when revenues change. Dont forget that it works both ways
the change in operating profit is magnified on the downside as well as the upside. That is
why it involves risk.



Summary

Operating leverage is an under-appreciated aspect of financial management. Much more
attention is paid to financial leverage, which is a big oversight.

The significance of operating leverage is, the greater the proportion of fixed operating costs
to operating total costs, the greater will be the change in EBIT when sales change. With
General Motors having very heavy fixed costs because of its labor contracts, a given
percentage of falling sales creates a magnified fall in EBIT. If 100% of costs were variable,
they would rise and fall in proportion to rises and falls in sales.

Leverage is a double-edged sword. When it cuts with you, its good because a given
percentage change in sales generates a magnified percentage change in profit. When it
cuts against you, the fall in sales, percentage-wise, generates a magnified drop in profit.

Most companies have more control over their financial leverage than over their operating
leverage. The fixed cost-variable cost relationship is determined to a great extent by the
nature of the industry. Modern auto manufacturers have sophisticated plants, which imply
high fixed cost. If they assembled the vehicles under a canvas shed behind a barn, using
itinerant labor and hand tools, hardly any of their costs would be fixed.






Operating Leverage
Company A Company B
YEAR 1 YEAR 2 YEAR 1 YEAR 2
Revenue 1000 2000 1000 2000
Fixed cost 200 200 0 0
Variable cost 600 1200 800 1600
Operating profit 200 600 200 400

33
CHAPTER 3
FORECASTING FINANCIAL STATEMENTS &
DETERMINING EXTERNAL FINANCING NEEDED

Learning Objectives
1. Use financial ratios as the basis of financial statement forecasts
2. Know that the forecast is driven by the anticipated growth rate in sales
3. Understand why and how the forecast reveals how much external financing is
needed to sustain the business plan portrayed in the forecast
4. Know difference between accounts that change spontaneously with sales and
those that change only when policy changes
5. Learn how to perform and interpret financial statement forecast in an Excel
spreadsheet

Percentage-of-Sales Forecasting of Financial Statements &
Determining External Financing Needed

This presentation draws on the previously discussed concept of sources and uses of funds:
The number at the bottom of the income statement, profit reinvested in the
business, is a source of funds (as long it is a positive number not a loss).
It is added into the equity side of the balance sheetthe sources of funds side,
along with increases in current liabilities, another source of funds.
Increases in the asset accounts, current assets and long-term assets, are uses of
funds, those needed to grow the business.
Then the two sides are totaled, with the plug figure making up the difference, where
uses exceed sources, showing external financing required
In the event that sources exceed uses, which may occur when a business is not
growing (a cash cow), the excess goes into cash. Thats why businesses that are
not growing, and are not increasing their assets, but remain profitable, are called
cash cows.

This chapter presents two ways to perform percentage of sales forecasting.
1. First, a short-form forecasting approach is designed to explain the concept and
methodology. It is directed a forecasting beginners who need to start with the
basics; it is more for pedagogy than it is for applications, because it is pared down
and simplified.
2. Then, a long-form forecasting approach is presented which has the depth and
complexity of a full-blown forecasting model.


The Short-Form Forecasting Model

The template below shows a short-form forecasting model for Leahy Bread Company, a
chain of bakeries with 1,027 locations. Notice 11 rows of income statement data followed
by 13 rows of income statement data, ending with a single row labeled External Financing
Needed. In the three left-hand columns, you see two years of history, 2010 and 2011. In
the three right-hand columns, you see a single forecast year, 2012. Everything is on a
single page of 32 rows and 7 columns, so you can see it all at once, without flipping pages
back-and-forth or scrolling through Excel. (By comparison, the Long-Form Forecasting
Model has 131 rows and 18 columns.)

34

Leahy Bread Company (LBC) is growing and building new bakeries. Revenues in 2011
were $828,971,000, with Net Income of $42,011,000, a return on sales of 6%, down from
8% in 2010. It has a term loan of $241,940,000, a big increase from the previous year;
much of it used to build new stores as Property, Plant and Equipment grew to
$495,000,000 in 2011, an increase of $226,191,000 from 2010, a 84% increase.

The Financial Director wants to know how much external financing will be needed, either
debt or equity, as of the end of 2012, so he uses the Short-Form Forecasting Model to get
a quick forecast. In Columns D and E, he enters the assumptions required for the forecast
based on 2011 historical results. He could use averages of both 2010 and 2011 instead, or
he could adjust any of the inputs based on his own judgment and knowledge of the
business and economic conditions. This is how he did it:
1. The forecast is driven by a planned 20% increase in revenues, entered in cell E5.
That percentage increase is high because of revenue from recently built stores.
2. The ratio of cost of goods sold to revenue was 75.8% in 2011, but he lowers it to
70% based on expected cost decreases for raw materials.
3. Depreciation is not driven by revenue as was cost of goods sold. Instead, it is driven
by the amount of depreciable assets, plant, property, and equipment. The
assumption is that depreciation will be 12.5% of PPE, entered as a number in E7.
4. E8 gets the ratio of g&a expense to revenue, C8 divided by C5, 7.7%, but this is
increased to 10% to allow for more advertising.
5. Interest expense in row 11 is 7% of the expected term loan outstanding during
2012. New financing is unknown until the finance director knows if more borrowing
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
32
A B C D E F G
(000) omitted 2010 2011 2012
history history forecast assumptions inputs formula forecast
Number of Bakeries 877 1,027
INCOME STATEMENTS:
Revenue 640,275 828,971 target growth rate 20.0% =C5*(1+E5) 994,765
Cost of Goods Sold 474,796 628,534 ratio: cgs/revenue 70.0% =E6*G5 696,336
Depreciation 33,011 44,166 $: 12.5% of ppe 61,875 =0.125*C23 61,875
General and Administrative 50,240 63,502 ratio: g&a/revenue 10.0% =E8*G5 99,477
Total Expenses 558,047 736,202 =G6+G7+G8 857,687
Operating Profit (EBIT) 82,228 92,769 =G5-G9 137,078
Interest Expense 3,246 16,931 7% of 2012 term loan =0.07*G8 16,936
Pretax Profit 78,982 75,838 =G10-G11 120,142
Tax 29,995 33,827 ratio: tax/pretax profit 44.6% E12*G12 53,589
Net Income 48,987 42,011 G12-G13 66,554

BALANCE SHEETS: 2010 2011
Cash and Short Term Investments 60,651 72,122 $: same as 2010 =C18 72,122
Accounts Receivable 25,158 30,919 ratio: rec/rev per day 30.0 =E19*(G5/365) 81,762
Inventory 7,358 8,714 ratio: inv/cgs per day 5.1 =E20*(G6/365) 9,654
Prepaid Expenses 9,607 15,863 $: 12,400 given given, no formula 12,400
Current Assets 102,774 127,618 =sum(G18.G21) 175,938
Net Property, Plant and Equipment 268,809 495,000 $: 640,000 given given, no formula 640,000
Total Assets 371,583 622,618 =sum(G22.G23) 815,938
Accounts Payable 8,222 10,842 ratio: pay/cgs per day 6.30 =E26*(G6/365) 12,012
Current Liabilities 8,222 10,842 =g26 12,012
Term Loan 46,383 241,940 term loan in place given, no formula 241,940
Total Liabilities 54,605 252,782 =G27+G28 253,952
Stockholder's Equity 316,978 369,836 previous+net income =C30+G14 436,390
Total Liabilities & Equity 371,583 622,618 =G29+G30 690,341
EXTERNAL FINANCING NEEDED EFN result =G24-G31 125,596

35
will occur. He does not know if more borrowing will occur until this forecast of EFN
is completed.
6. The income tax rate in E13 is calculated by dividing C13 by C12.
7. Cash and short term investments in row 18 does not change.
8. E19 gets a much higher ratio of receivables to revenue per day instead of 13.6 days
in 2011. Increased catering and more commercial accounts will cause a longer
collection period, 30 days.
9. Inventory is perishable and turns rapidly, so E20 gets the ratio of inventory to cost of
goods sold per day of 5.1 days.
10. Prepaid expenses is a given, 12,400 in G21, because it is expected to fall to this
level at the end of 2012.
11. Property, plant, and equipment will increase from 495,000 at the end of 2011 to
640,000 at the end of 2012, so 640,000 is entered in G23.
12. Payables are based on the 2011 level of 6.3 days.
13. The term loan remains at 241,940, so that amount goes into G28.
14. Stockholders equity is the sum of the previous years amount plus the net
income for the current year, so F30 gets the sum of C30 plus G14. If dividends
are paid in cash, F14 must be reduced by the amount of the dividends.
15. The final step is deducting the total of USES of FUNDS (G24) from SOURCES
OF FUNDS (G31) to get EXTERNAL FINANCING NEEDED. Total Assets are the
total of funds used in the business the amount that must be invested to
generate the revenue on the income statement. Total Liabilities and Equity is the
sources of funds, where the money comes from. In this forecast, USES are
$125,596 higher than SOURCES, meaning that that much money must be raised
from either debt or equity financing by the end of 2012.

You just witnessed the process of making a forecast, from beginning to end. Data from
the past was used in combination with judgment about the future based on knowing the
business. Realize that the bullet points in the step-by-step process listed above can be
categorized in two ways:
1. Those that are based on ratios, such as rows 5 (revenue), 6 (cost of goods
sold), 8 (general and administrative expense), 13 (tax), 19 (receivables), 20
(inventory), and 26, (payables). For each of these entries, the input in Column E
either has a ratio based on historical experience or it is overridden by expert
judgment; then a formula in Column F does the calculations, using the input in
Column E. Financial analysts refer to these entries as spontaneously changing
as revenues change; they are revenue driven.
2. Rows 7, 11, 18, 21, 23 and 28 do not have inputs in Column E because they are
not driven by historical ratios (or revised based on expert judgment) used in the
formulas in Column F, but entered directly in Column F as amounts of money.
These entries do not change spontaneously with revenues, but must be
determined by managers.




36

The Long-Form Forecasting Model (LFFM)

The forecasting process results in projected income statements for the next five years,
2012-2016. Forecast for shorter or longer periods by deleting or adding columns or leaving
them blank.

Starting with the first row of the income statement, revenue, and go down row-by-row,
entering your educated guess in each of the assumption cells, based on historical ratios
and intentions about the future. Then, you do he same thing for the balance sheet, working
row-by-row. The forecasts are in nominal terms, with inflation already imbedded in the
forecasted growth rate.

You can control the assumption for each of the rows and each of the time periods rather
than using the same one across all periods as some forecasting models do. Also, notice
that the number of accounts in the financial statements is extensive - rows labeled other
lets you customize to some extent, as long as the formulas do what you intend them to do.
Always be aware of what the formulas in the forecast cells, Columns M.Q, are doing with
the assumptions you enter in Columns H.L.

(some columns not shown, best viewed at 150% or 175% magnification, go to Template Set.xls for all-column view)


Step-by-Step Forecast of Income Statement

1. Enter data from historical income statements in Columns B-F. The labels in Column
A in the Long-Form Forecasting Model may not exactly match the labels in the
statements you are working from, so it will be necessary to fit the source data to the
model; use catch-all Other category as necessary. Be careful not to disturb
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
A E F G H I J K L M N O
INCOME STATEMENT
.forecast assumptions.. .forecast..
PERIOD -1 0 1 2 3 4 5 1 2 3
JANUARY 1-DECEMBER 31 2010 2011 2012 2013 2014 2015 2016 2012 2013 2014
0.5
Revenue 869.5 1224.0 revenue growth rate 10.0% 12.0% 12.0% 12.0% 8.0% 1346.4 1508.0 1688.9
Cost of sales (661.9) (797.0) cost of sales/revenue 66.0% 67.0% 64.0% 63.0% 63.0% (888.6) (1010.3) (1080.9)
Gross profit 207.6 427.0 457.8 497.6 608.0
Other operating income 6.7 10.1 estimated amount 10.1 10.1 10.1 10.1 10.1 10.1 10.1 10.1
Distribution costs (52.7) (108.3) cost/revenue 8.8% 8.0% 7.2% 6.5% 6.0% (119.1) (120.6) (121.6)
Administrative costs (84.4) (149.1) cost/revenue 12.2% 12.2% 12.2% 12.2% 12.2% (164.0) (184.0) (206.0)
Depreciation & amortization expense 0.0 0.0 % of ppe 7.5% 7.5% 7.5% 7.5% 7.5% (65.4) (65.4) (65.4)
Other operating costs (17.7) (23.4) cost/revenue 1.9% 1.9% 1.9% 1.9% 1.9% (25.7) (28.7) (32.1)
Restructuring costs 0.0 (18.3) estimated amount 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0
Total operating costs (810.0) (1086.0) (1252.8) (1398.9) (1496.0)
Profit from operations (EBIT) 59.5 138.0 93.6 109.0 192.9
Interest, financing expense (33.0) (36.7) 0.0 0.0 0.0
Income from investments 1.7 15.7 estimated amount 5.0 5.0 5.0 5.0 5.0 5.0 5.0 5.0
Disposal of operations 0.0 8.5 estimated amount 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0
Profit before tax 28.2 125.5 98.6 114.0 197.9
Income tax (4.4) (19.6) average tax rate 15.6% 15.6% 15.6% 15.6% 15.6% (15.4) (17.8) (30.9)
Profit after tax 23.8 105.9 83.2 96.2 167.0
Minority interest (0.1) (0.6) 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0
Other 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0
Net profit 23.7 105.3 83.2 96.2 167.0
Dividends (8.0) (5.0) payout ratio 10.0% 15.0% 20.0% 25.0% 25.0% (8.3) (14.4) (33.4)
Other 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0
Reinvested in the business 15.7 100.3 74.8 81.8 133.6

37
formulas, entering data only in blank data-entry cells. Remember that income
statement entries represent flows during the time period.
2. Estimate revenue growth H8.L8 as a percentage for each year of the five-year
planning periods beyond the base year in Column F. The growth rates set here
combine unit and price level increases into a single growth rate.
3. Enter percentages for each of the operating expense items for each time period:
cost of sales in H9.L9, distribution costs in H12.L12, and administrative costs in
I13.L13. Base them on historical ratios and judgment on their likely behavior in the
future. The formulas in the template multiply your assumed ratio by the revenue for
that period, the essence of the percentage-of-sales method of forecasting. A
complication lies in the assumption that all operating costs are variable with respect
to revenue, which simplifies reality. The income statement uses the format of
published financial statements, which do not break out fixed and variable costs
separately.
4. Other operating income (if any) H11.L11 is entered as a number, not a ratio; no
formula is involved. The number entered in the assumption cell is entered in the
forecast cell.
5. Depreciation and amortization expense in H14.L14 is forecasted as a percentage of
prior year depreciable fixed assets and can be derived from information in the
footnotes to published financial statements. Often, depreciation expense is included
in cost of goods sold and other expense accounts, and is not shown as a separate
item; in that case leave H14.L14 blank.
6. Other operating costs in H15.L15 are left blank unless this category is needed for
other items that are forecasted as a percentage of revenue.
7. Restructuring costs, if any, are entered in H16.L16 as a number.
8. Entering interest, financing expense in H19.L19 is challenging. Until the forecast is
complete, the amount of external financing needed is not known. Since the amount
of financing is not known, interest expense cannot be known either. For existing
loans and debt that will not be repaid during the forecast period, enter interest
expense for that debt; for existing loans and debt that will be repaid during the
forecast period, enter zero. Enter them as nominal numbers.
9. Income from investments in H20.L20, disposal of operations in H21.L21, H25.L25
minority interest, and H26.L26 other are entered as numbers if these categories are
relevant. No formulas are involved; the amount entered in the forecast cell is
transferred to the forecast cell.
10. The income tax rate in H23.L23 is based on historical income tax rates and is
entered as a percentage.
11. The dividend payout ratio in H28.L28 is based on historical dividend payout ratios. If
the dividend is given as a number, convert it into a ratio.

To understand how Excel calculates the forecast, put your cursor on the forecasted
cells, Columns M.Q for each row. You will see how the assumption is used in a formula
to calculate the forecasted item. Please take special care to recall, just as in the Short-
Form Forecasting Model, that some line items forecast with an assumed ratio, others
forecast with a number. Where the assumption cell contains a ratio, a formula in the
forecast produces the result. Where the assumption cell contains a number, that number
is transferred to the forecast cell.

For Cells B33.F39, enter data if they are available.



38

Step-by-Step Forecast of Balance Sheet Forecast

(some columns not shown, best viewed at 150% or 175% magnification, go to Template Set.xls for all-column view)

The forecasted balance sheets are prepared by entering a reasonable estimate of the
projected assumption in each row, just as you did with the income statement forecast.
Remember that balance sheet entries represent end-of-period balances.

Some balance sheet accounts change spontaneously with changes in revenue; others
change only as a result of policies decided by the managers of the business. It is important
to distinguish between those accounts that change spontaneously, such as
accounts receivable
inventory
accounts payable
41
42
43
44
45
46
47
48
49
50
51
52
53
54
55
56
57
58
59
60
61
62
63
64
65
66
67
68
69
70
71
72
73
74
75
76
77
78
79
80
81
82
83
84
85
86
87
88
89
90
91
92
A E F G H I J K L M N O
BALANCE SHEET
.forecast assumptions.. .forecast..
PERIOD -1 0 1 2 3 4 5 1 2 3
AS OF DECEMBER 31 2010 2011 2012 2013 2014 2015 2016 2012 2013 2014
ASSETS
Current assets:
Cash & equivalents 1.2 5.6 % of revenue 0.5% 0.5% 0.5% 0.5% 0.5% 6.2 6.9 7.7
Investments 29.7 37.2 estimated amount 37.2 37.2 37.2 27.2 27.2 37.2 37.2 37.2
Trade receivables 179.5 188.9 days revenues 50.0 52.0 54.0 56.0 58.0 184.4 214.8 249.9
Inventory 108.6 117.9 days cost of sales 50 55 55 60 60 121.7 152.2 162.9
Other 0.0 0.0 0 0 0 0 0 0.0 0.0 0.0
Total current assets 319.0 349.6 349.5 411.2 457.7
Non-current assets:
Property, plant & equipment-gross 600.4 722.5 estimated capex 150.0 0.0 0.0 150.0 0.0 872.5 872.5 872.5
Accumulated deprec. & amort. (33.6) (62.9) by formula (128.3) (193.8) (259.2)
Property, plant & equipment-net 566.8 659.6 744.2 678.7 613.3
Investment property 11.4 12.0 12.0 12.0 12.0 12.0 12.0 12.0 12.0 12.0
Goodwill 0.1 0.6 0.6 0.6 0.5 0.5 0.4 0.6 0.6 0.5
Other 1 167.1 213.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0
Other 2 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0
Total non-current assets 745.4 885.2 756.8 691.3 625.8
Total assets 1064.4 1234.8 1106.3 1102.5 1083.5
LIABILITIES AND EQUITY
Current liabilities:
Trade & other payables 86.3 141.9 days cost of sales 50 55 60 60 60 121.7 152.2 177.7
Retirement benefit obligation 4.5 3.8 estimated amount 4.0 4.0 4.0 4.0 4.0 4.0 4.0 4.0
Tax liabilities 2.0 8.2 %age of curr inc tax 40.0% 40.0% 40.0% 40.0% 40.0% 6.2 7.1 12.4
Leases due in 1 year 1.5 1.5 1.5 1.5 1.5 1.5 1.5 1.5 1.5 1.5
Loans, debt due in 1 year 102.5 111.9 112.0 112.0 112.0 112.0 112.0 112.0 112.0 112.0
Other 2.0 8.6 8.6 8.6 8.6 8.6 8.6 8.6 8.6 8.6
Total current liabilities 198.8 275.9 254.0 285.5 316.1
Non-current liabilities:
Retirement benefit obligation 34.0 30.2 estimated amount 30.2 30.2 30.2 30.2 30.2 30.2 30.2 30.2
Deferred tax liabilities 6.4 15.4 estimated amount 15.4 15.4 15.4 15.4 15.4 15.4 15.4 15.4
Finance leases due after 1 year 1.2 0.9 1.0 1.0 1.0 1.0 1.0 1.0 1.0 1.0
Loans, debts due after 1 year 474.9 413.1 413.0 413.0 413.0 413.0 413.0 413.0 413.0 413.0
Other 0.0 0.0 estimated amount 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0
Total non-current liabilities 516.5 459.6 459.6 459.6 459.6
Total liabilities 715.3 735.5 713.6 745.1 775.7
Stockholder's equity:
Preferred stock 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0
Common stock 120.0 120.0 120.0 120.0 120.0 120.0 120.0 120.0 120.0 120.0
Paid-in surplus 32.1 32.9 estimated amount 32.9 32.9 32.9 32.9 32.9 32.9 32.9 32.9
Other 35.1 83.5 estimated amount 83.5 83.5 83.5 83.5 83.5 83.5 83.5 83.5
Retained earnings 159.3 259.7 prev r/e + curr reinv prof 334.5 416.3 550.0
Total equity 346.5 496.1 570.9 652.7 786.4
Minority interest 2.6 3.2
Total liabilities & equity 1064.4 1234.8 1284.5 1397.8 1562.1

EXTERNAL FINANCING NEEDED: (178.2) (295.3) (478.6)

39
and those that change only when management decides to change them, by a change in
policy, by an actual decision, such as:
fixed assets

(Some analysts increase fixed assets in proportion to increases in
revenues. This may be an unwise short cut. It fails to take excess capacity into
account. It also fails to consider that fixed assets are not necessarily scalable to
revenue increases.)
short-term borrowing
long-term borrowing
dividend payout
equity repurchase
equity issue

Remember that the net working capital accounts of receivables, inventory, and payables
are determined by two inputs:
receivables is calculated by revenue per day x number of days of revenues in
receivables (collection period) revenue is a spontaneous change, but the days
revenues in receivables is a policy issue determined by managers if they want to
tighten credit terms, they reduce the number of days, and vice versa.
inventory is calculated by cost of goods sold per day x number of days of cost of
goods sold in inventory cost of goods sold changes when revenue changes, but
the number of days of cost of goods sold is a policy decision that is adjusted by
managers.
payables is calculated by cost of goods sold per day x number of days of payables
in cost of goods sold the number of days of payables is a policy decision that is
adjusted by managers if they pay their suppliers quickly the number of days is
lower.

1. For H47.L47, estimate the minimum cash balance based on the historical trend. For
most businesses, cash is not driven by sales, so this forecast is a rough guestimate.
Some analysts prefer to enter a number amount in H47.L47, and change the
formulas in M47.Q47 to accept those numbers. Investments in H48.L48 is entered
as an amount.
2. Set trade receivables in H49.L49 as the number of days revenue in receivables. As
just stated above, the number of days is a policy matter - it can be smaller or larger
depending on how generous managers want to be in extending credit to customers.
But, once the number of days is set, accounts receivable changes spontaneously
with revenues. For example, a 60-day collection period, favored by the marketing
department, means that the firm must invest twice as much in receivables
compared to a 30-day collection period. No provision for uncollectible receivables is
made in this forecast.
3. Set inventory in H50.L50 as the number of days costs of sales in inventory. It can
rise or fall throughout the period, depending on judgments about competitive
conditions, breadth of product lines, the production cycle, and other relevant factors.
But once the number of days is set, inventory behaves spontaneously in response
to changes in revenue levels.
4. Use other in H51.L51 if necessary, entering a number which is transferred to the
forecast cell.
5. All non-current asset assumptions, except accumulated depreciation in H55.L55,
are entered as numbers and are transferred directly to the forecast cells. They do
not change spontaneously when revenue changes; they are determined by
engineering estimates comparing existing capacity with forecasted capacity. Many

40
businesses have excess plant capacity and are able to increase production without
buying new plant, property and equipment. Care should be taken so that production
levels implied by revenue do not exceed plant capacity. Increases in fixed assets
should be made only for revenue increases requiring production that exceeds
existing capacity. When revenue increases solely because of price increases, no
additional plant capacity is needed.
6. Accumulated depreciation is calculated automatically; no entry is required.
Formulas take depreciation expense from row 14 on the income statement to adjust
accumulation depreciation on row 55 of the balance sheet. When the source
financial statements do not specify depreciation expense, but include it with cost of
goods sold and other expense items, the forecast of depreciation expense (IS) and
accumulated depreciation (BS) will not be accurate.
7. H57.H60 contain numerical assumptions for investment property, goodwill, and
other. Leave them blank if not relevant.
8. Trade payables in H66.L66 is entered as the number of days cost of sales; it
changes spontaneously with sales. For example, a 10-day payment period may
mean that the firm can take advantage of discounts offered by suppliers if they
receive payment quickly. But, since accounts payable is a source of funds (supplier
financing), as the payment period falls, the firm must find other sources of financing
if it reduces its payment period. Financing not provided by trade credit must be
provided elsewhere.
9. Retirement benefit obligation, if known, is entered as a number in H67.L67.
10. Tax liabilities in H68.L68 is entered as a percentage of income tax on the income
statement. It represents income tax due to the government.
11. Leases dues in one year in H69.L69 and loans due in one year in H70.L70 are
entered as numbers indicating the outstanding amount at the end of the time
period. These numbers can be entered as zeroes, consistent with their status as
current liabilities, due in one year. After external financing needed is calculated,
financial managers will decide how much of that external financing need can be
provided by short term leases and borrowing.
12. Retirement benefit obligation in H74.L74 and deferred tax liabilities in H75.L75 are
entered as numbers, if known and relevant.
13. Leases and loans in H76.L76 and H77.L77 include only items that are outstanding
in the base year and will not be repaid in the forecast years. Reduce the lease
amount by annual payments scheduled. Reduce the loan amount by annual
principal payments scheduled.
14. Other in H78.L78, if any, is entered as a number.
15. Entries in H82.L85 for preferred stock, common stock, paid-in-surplus, and other
are entered as numbers from the base year. New financing should not be entered
because it depends on the external financing needed, the result of the forecast, and
decisions by the managers and their advisers.
16. Add Reinvested in the business balance from the income statement forecasts to
equity on the balance sheet, linking the income statements with the balance sheets.
17. Retained earnings in H86.L86 needs no entry. It is calculated automatically by
summing the previous period retained earnings (row 86) from the balance sheet
and current period reinvested in the business (row 30) from the income statement.
18. Enter minority interest in H88.L88 if known and relevant.
19. Examine the total assets (row 62) and the total liability plus equity (row 89) of the
balance sheet. Notice that the two sides do not balance. Usually, in a growing
business, the asset side (uses of funds) will show a higher amount than the liability
plus equity side (sources of funds), which means that external financing (EFN) is

41
needed. Row 91 subtracts row 62 from row 89, calculating EFN. A positive number
for EFN indicates a shortage of uses over sources, telling you that external
financing is needed and must be arranged. A negative number of EFN indicates a
surplus of sources over uses, telling you that no external financing is needed and
that the business will generate cash. IMPORTANT: Since balance sheets cumulate
end-of-period balances, the EFN numbers in cells M91.Q91 must be interpreted as
cumulative, not additive. This vital is discussed below.

To understand how Excel calculates the forecast, put your cursor on the forecasted
cells, Columns M.Q for each row. You will see how the assumption is used in a formula
to calculate the forecasted item. Please take special care to recall, just as in the Short-
Form Forecasting Model, that some line items forecast with an assumed ratio, others
forecast with a number. Where the assumption cell contains a ratio, a formula in the
forecast produces the result. Where the assumption cell contains a number, that number
is transferred to the forecast cell.

Circularity Between Interest Expense (IS) & External Financing Needed (BS)

The financial statements forecasted above must be considered as preliminary; they are
incomplete. Financing cost, as shown on the projected income statement, measures only
the interest on the existing debt. If external financing need is raised from debt sources,
financing cost rises. This causes profit after tax to fall, which in turn causes external
financing needed to rise. Refer to the IS/BS Model to visualize what happens because the
income statement and balance sheet are linked. For example, you assume that all external
financing will be accomplished with long-term debt with an interest rate of 9%. Finance cost
on the income statement is adjusted to reflect this. But, as finance cost rises, profit falls.
Since profit is added to equity, equity also falls. Falling equity, a source of funds, causes
external financing to rise. This circularity cannot be avoided; it is inherent in the process of
preparing forecasted financial statements. Since the forecast is based on estimates that
have a degree of error in them, many analysts do not refine the results, accepting this first
iteration of the forecast as a reasonable estimate of external financing needed.

I rely on what is called the cavalier approach to forecasting. It works because the forecast
usually gives a meat-axe rather than a scalpel-cut result, so why pretend otherwise. If the
purpose of the forecast is to tell you how much external financing is required, the cavalier
approach gets you close enough.


42

Interpreting External Financing Needed (EFN)

The chart above illustrates the behavior of financing needs over time. As revenue
increases, the need for both fixed assets and net working capital increases, with the
magnitudes shown by the slope of the lines. Part of net working capital is permanent, i.e.,
its minimum level., stepping up each year as plan, property and equipment increases to
support growing revenue. Another part is temporary, i.e., it cycles up and down according
to seasonal trends. (With no seasonal trend, the cyclical up-down lines on the chart would
not exist.) Permanent funding is required for permanent increases in assets needed as the
business grows, and temporary financing is suitable for temporary needs. Temporary
borrowing is revolving credit that is used when needed, and repaid when not needed.

A forecast estimated these external financing needs of Company X for 2007-2011, as
below:

Interpret the figures for external financing needed as cumulative, meaning the amount of
financing needed through the end of that period. By the end of 2007, this company needs
178.2 million dollars of external financing, if it operates at the revenue growth levels
projected. By the end of 2008, external financing has grown to 295.2, an increase of 117.0.
By the end of forecast period in 2011, the external financing need has become 743.2
suggesting that about three-quarters of a billion dollars are needed to support the growth
plan where revenue increases.

Seasonal (Short-Term) vs. Permanent (Long-Term) Financing

You can calculate a one-year forecast with monthly periods. The pattern of external
financing needed on this monthly forecast can be used to tell whether you will need
seasonal short-term loans or permanent long-term borrowing

Seasonal borrowing is temporary because you use it to build inventory and carry accounts
receivable for only that part of the year when your business operates at peak levels. Called
short-term inherently self-liquidating (STISL) loans, the proceeds of the loan are used to
buy inventory. When that inventory is sold, accounts receivable increase; eventually, those
receivables are collected and the cash received is used to repay the loan. Because both

43
inventory and receivables decrease at the end of the peak selling season, the financing
requirement is temporary; it is repaid as receivables are collected and cash becomes
available. This type of loan is called a balance sheet loan because the source of repayment
comes from the balance sheet as current assets cycle from inventory to receivables to
cash.

Permanent borrowing is not repaid within one year. Usually, the source of repayment
comes from profits, so this type of loan is called an income statement loan.

Borrowing requirements may be temporary or permanent. The first cash flow pattern below
shows a deficit in January through April, followed by a surplus in May through August, and
again a deficit in September through December. The May through August surplus shows
that the loan is zero during these months. Therefore, it is a true temporary, inherently self-
liquidating working capital line of credit, cleaned up during part of the year, and drawn on as
peak needs build up again. Notice that the loan increases from September through
January, assuming that the annual seasonal cycle repeats. It peaks at 50, then, falls as the
loan is repaid at a rate of 10 each month until May when all of it is repaid. All borrowing
shown here is STISL; borrow when you need it - repay when you do not need it.


If deficits of varying amounts are shown for each month, the interpretation of financing
needs becomes more complex. In the second cash flow pattern below, you see cash flow
deficits rising, indicating a seasonal pattern. But, because the deficits never shift to
surpluses, and the deficits have a minimum level of 30, this defines the minimum level of
borrowing, the borrowing that is needed every month, i.e., permanent borrowing. When
permanent borrowing of 30 is in place, it is shown as an inflow, netting out to the STISL
loan cycling up and down, leaving zero balances in the months when it is cleaned up.


The third cash flow pattern below indicates that cash requirements are steadily increasing
because of secular growth, and that permanent financing is required.


Mismatch of Intra-Period Cash Flows

The forecasts above were structured to give results for the end of each month. This
approach assumes that inflows and outflows of cash are evenly matched throughout the
month. Instead, assume that all of the outflows occur in the first five days of the month, and
all of inflows occur in the last 10 days of the month. Even though you have a forecast telling
you that no borrowing is necessary, you will not have the money to pay your bills during the
first five days because the money will not start to flow for at least 10 more days.

To avoid creating a forecast that gives false signals of security, be aware of the timing of
the intra-month cash flows. It is for this reason that some businesses budget cash on a
daily basis. You can solve the mismatch problem by having the ending date of the forecast




JAN FEB MAR APR MAY JUN JUL AUG SEP OCT NOV DEC
Surplus (Deficit) -50 -40 -30 -20 10 20 30 40 -10 -20 -30 -40

JAN FEB MAR APR MAY JUN JUL AUG SEP OCT NOV DEC
Surplus (Deficit) -50 -40 -30 -30 -30 -30 -30 -30 -30 -30 -40 -40
Permanent f ianncing 30 30 30 30 30 30 30 30 30 30 30 30
STISL -20 -10 0 0 0 0 0 0 0 0 -10 -10

JAN FEB MAR APR MAY JUN JUL AUG SEP OCT NOV DEC
Surplus (Deficit) -10 -20 -30 -40 -40 -45 -50 -55 -60 -60 -65 -70

44
coincide with the low ebb of cash for that month. Pick the date when your excess of
outflows over inflows is at its greatest level.

Horizontal totals

Be careful about adding across the lines of a spreadsheet to derive annual totals. You can
do this for the rows in the income statement, because they are flows occurring during a
time period. Do not do it for balance sheet lines, because these figures are end-of-period
balances, already on a cumulative basis - they are not additive. Make a mental note about
this!

Forecasting and inflation

Revenue in dollars is the product of units sold (volume) multiplied by the price of each unit.
It is important to realize what proportion of a revenue increase comes from unit revenue
(real), and what comes from change in the unit price (nominal). In forecasting income
statements and balance sheet items, the forecast should be made in nominal terms.
Revenue and expenses are stated in nominal dollars because this is the amount of money
that flows in and out of the business. In the balance sheet, accounts receivable, inventory,
and accounts payable are stated nominally because they reflect the prevailing prices of
goods and services bought and sold. But fixed assets is another story because only real
increases in revenue exhausts excess fixed asset capacity. Therefore, when forecasting
fixed assets, be careful to consider only the impact of real revenue increases. If revenue
increases 10% per year, and the whole increase comes from price inflation, unit production
of goods does not change so plant capacity does not have to be increased.

Summary

A financial statement forecast that increases all accounts by the projected growth rate in
sales is wrong-headed because
Receivables, inventory, and payables spontaneously change as sales changes
i.e., the are driven by sales
Most other accounts are policy-determined they are not driven directly by sales
Property, plant and equipment is not necessarily going to increase when sales
increases, if excess capacity is available, or if sales increases are inflationary
with no rise in unit sales

A major purpose of a financial statement forecast is to find out how much external
financing (EFN) is required to support the business plan. It is the plug figure that forces
a balance between sources and uses of funds. At this point in the course, no decision is
made about how to provide EFN, from short-term borrowing, long-term debt, or equity
sources.

When interpreting the EFN row of a forecast, make sure to examine the sign carefully.
When uses of funds exceed sources, EFN is needed. When sources exceed uses, EFN
may be stated as a negative number, which is interpreted as a surplus. In this instance,
the plug is to cash.

When interpreting the EFN row of a forecast, remember that the figures come from
balance sheets and are cumulative never add them. When EFN rises from one period
to the next, it means that EFN is increased by the difference between the two amounts.

45
When EFN falls from one period to the next, it means that EFN is reduced by the
difference between the two amounts. The EFN in the final period tells you the total EFN
for the entire planning period.

Now that you know now to forecast, a look at this deceptively simple diagram will bring
home an important point about the relationship between revenue (sales) growth and the
balance sheet. You will soon learn that an income statement all by itself does not contain
enough metrics to judge the performance of a business the balance sheet is needed
too. You will learn that Free Cash Flow is a better performance metric than Net Income,
because it combines income statement and balance sheet information, i.e.,

FREE CASH FLOW = EBIT TAX + DEP +/- CHANGE IN NWC +/- CHANGE IN PPE

The first three terms come from the income statement (EBIT, tax, depreciation); the last
two terms come from the balance sheet (net working capital, property, plant, equipment).
The analysis below is a striking picture of external financing needs and their drivers that
demonstrates how the cash flows in a business operate.

This diagram looks like a balance sheet but it is more than that. Know that the label in
row 4 says revenue change because it could be an increase or decease.


Assets that grow spontaneously as revenue grows are expressed as
percentages of revenues, as shown in Cells D10 and I10. As long as the days
revenues in receivables, inventory, and payables are not changed, these ratios
can be expressed as percentages of revenues. Think of it as one dollar of
additional revenue requiring 27.3 cents of additional receivables + inventory, and
11 cents of additional payables plus other accruals.
The fixed assets, property, plant and equipment require more analysis. It is
possible for revenue to growth with no increase in fixed assets if excess capacity
in PPE is available. Therefore, fixed asset increase should never be expressed
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
A B C D E F G H I
FOR EACH $1 CHANGE IN REVENUE:
Assumptions:
revenue 2694
net profit margin 1.6%
CHANGE IN ASSETS (USES OF FUNDS) CHANGE IN LIABILITIES+EQUITY (SOURCES OF FUNDS)
cents cents
CURRENT ASSETS CURRENT LIABILITIES
RECEIVABLES 317 PAYABLES 256
INVENTORY 418 OTHER ACCRUALS 39
CA/SALES 27.3 CL/SALES 11.0
FIXED ASSETS LONG-TERM DEBT 0
PLANT
PROPERTY EQUITY
EQUIPMENT INCR IN RET EARN/SALES 1.6
FA/SALES 0.0
TOTAL FORECASTED SOURCES 12.6
EXTERNAL FINANCING NEEDED 14.7

TOTAL FORECASTED USES 27.3 ADJUSTED TOTAL FORECASTED SOURCES 27.3

46
as a percentage of revenue without considering engineers estimates of actual
PPE increases in dollars, which are then converted to a percentage, entered in
D13.D15, although this example has no PPE increase.
Long-term debt is not driven by revenue growth. Instead, it is a conscious
decision. Therefore, enter 0 cents in I12.
Equity grows with growing revenue via net profit. Therefore, the net profit margin
shows the sources of funds generated this way, 1.6 cents entered in I15.
D21 shows cents of total uses of funds (increases in asset accounts per dollar of
revenue increase). I17 shows 12.6 cents of total sources (increases in liability
and equity accounts per dollar of revenue increase). Then, I19 subtracts total
sources from total uses to calculate 14.7 cents External Funds Needed. A
positive number tells you that sources are less than uses, requiring external
financing. A negative number tells you that sources exceed uses, providing a
surplus, with no need for external financing.
I21 is the sum of total sources in I17 and external financing needed in I19 to get
the new total of sources, balancing with total uses in D21, both 27.3 cents.

Its not as complex as it seems. Look at this table with simplified entries to see the
essence of what the above diagram is telling you. Receivables increase by 3 plusses,
inventory by 2, and PPE by 2 that means 7 in USES of funds. Payables increase by 2
plusses and retained earnings by 1 that means 3 in SOURCES of funds. 7 USES less
3 SOURCES means a shortage, EFN, of 4. Add in EFN, and the balance sheet
balances, 7 and 7.













Think back to both the short-form and long-form financial forecast covered in this
chapter. Each one forecasted an income statement and a balance sheet. If uses and
sources in the balance sheet did not balance, external financing required provided the
plus figure to force a balance. The analysis just presented in the form of a pared-down
balance sheet shows you the same process, minus all of the row-by-row detail. You can
take in the whole process of estimating EFN with one diagram covering half a page.

Most revealing is that for most companies operating in competitive environments, the
asset side of the balance sheet is likely to grow faster than the liability and equity side.
This means that external financing will always be needed as long as revenues grow.

Now that you understand what the table portrays, realize its importance for most
businesses, the left side (USES of funds) of their balance sheets grow faster than their
right sides (SOURCES of funds). This means that the money to support growth of the
Assets Liabiliies & Equity
Receivables +++ Payables ++
Inventory ++
PPE ++ Retained Earnings +
Total +++++++ Total +++
EFN ++++

47
business must come from external sources. Examine the following four examples to
reinforce the concept.

The first box shows current assets increasing by 30 cents per dollar of revenue increase,
with no PPE increase because of excess plant capacity, 20 cents of current liabilities
increase, and 5 cents of profit margin. EFN equals 5 to balance use and source.












The second box increases PPE from zero to 10 with everything else the same. The
additional 10 of uses causes EFN to increase from 10 to 15.













The third box is an atypical business with a very high profit margin, 30%. It may be a
semi-monopolistic company like Microsoft. EFN is negative because high profit margin
causes sources of 50 to exceed uses of 30. For most businesses, high profit margins
attract competitors, driving down the profit margin.












ASSETS (SOURCES) LIABILITIES (USES)
Current Assets 30 Current Liabilities 20
PPE 0 Long-term debt 0
Equity 30
Change in Sources 50
EFN (Plug) -20
Change in Uses 30 Adj Chg in Sources 30
CHANGES STATED AS CENTS/$ REVENUE CHANGE
ASSETS (SOURCES) LIABILITIES (USES)
Current Assets 30 Current Liabilities 20
PPE 0 Long-term debt 0
Equity 5
Change in Sources 25
EFN (Plug) 5
Change in Uses 30 Adj Chg in Sources 30
LIABILITIES (USES)
Current Assets 30 Current Liabilities 20
PPE 10 Long-term debt 0
Equity 5
Change in Sources 25
EFN (Plug) 15
Change in Uses 40 Adj Chg in Sources 40
CHANGES STATED AS CENTS/$ REVENUE CHANGE
ASSETS (SOURCES)

48
The fourth box shows a no-growth scenario, portraying a CASH COW. No changes in
either assets or liabilities because revenue does not grow, so profit margin is a source of
funds with no uses.



CHANGES STATED AS CENTS/$ REVENUE CHANGE
ASSETS (SOURCES) LIABILITIES (USES)
Current Assets 0 Current Liabilities 0
PPE 0 Long-term debt 0
Equity 5
Change in Sources 5
EFN (Plug) -5
Change in Uses 0 Adj Chg in Sources 0

49

CHAPTER 4
FINANCIAL ARITHMETIC THE TIME VALUE OF MONEY

Knowledge of financial arithmetic is crucial, as is tying knots for surgeons. You must know it
because these techniques are the conceptual underpinnings of financial analysis.

Time value of money is the workhorse concept of financial analysis. It is based on the
simple fact that the 1 euro you have today is no longer 1 euro tomorrow. By tomorrow,
today's 1 euro will be worth more because it earns interest. If money is worth 12% per year,
that is the same as 1% per month or .03% per day. So 1 euro today is worth 1.0003
tomorrow or 1.12 one year later (using annual compounding). Accordingly, you will pay less
than 1 euro right now, today, for the right to receive 1 euro tomorrow. This is the impact of
compound interest.
2
Each day, the amount grows, with the original 1 euro earning interest
and the interest earning interest.
3
Just ask yourself if you are indifferent about receiving
1,000 either right now or one year from now. Most people, including all of the rational ones,
prefer to receive the money now rather than later. This is why one euro today is worth more
than one euro tomorrow. Today's 1 euro will be worth 1.003 tomorrow; that is more than
waiting until tomorrow to get the 1 euro.

Because of the time value of money, when a financial analyst compares amounts of money
(cash flows), the time dimension must always be taken into account (unless all of the cash
flows occur at the same moment). When evaluating cash flows at various dates in the
future, the financial analyst adjusts them to their equivalent value as of one point in time,
using an estimated interest rate:
If the equivalent value is at the initial date, the process is called discounting, or
discounting to present value. Present values are smaller than future values.
If the equivalent value is at the terminal date, the process is called compounding, or
growing, or compounding to future value. Future values are larger than present values.
The interest rate used for the process is called either the discount rate or the growth
rate. It measures the cost of money.

Basics of Time Value of Money

A lump sum is an amount of money paid or received at one date.
An annuity is a series of amounts of money, periodic payments, all in the same amount,
paid or received over a period of time with constant time intervals.







2
The difference between the simple interest formula i = prt that you learned in primary school is that
compounding involves interest-on-interest. The simple interest formula works only when there is a
single compounding period. Otherwise, it will give you an incorrect result.
3
You may imagine that inflation is the reason why today's euro is worth more than tomorrow's euro.
This is incorrect. The cause is the time value of money.

50
Table 4.1


Table 4.1 shows you four
4
possible calculations, PV of lump sum, PV of annuity, FV of
lump sum, and FV of annuity. The two lump sum calculations use the basic time value of
money formula, (1+i)
n
. To get a PV, you multiply the future amount by the reciprocal of the
formula. To get a FV, you multiply the present amount by the formula. The four tables at the
end of the chapter, referred to in Table 4.1, are nothing more than combinations of the time
value inputs, i for the interest rate, and n for the number of periods. This chapter explains
how this works.

There are only five possible parameters involved. Lump sum calculations involve only four
of them, because there is no periodic payment. Your aim is to identify the known values
and solve for the unknown value:
1. a periodic interest rate, i
2. a number of time periods, n, starting at an initial date and ending at a terminal date
3. a Present Value, PV
4. a Future Value, FV
5. a Periodic Payment, pmt


The Growth Rate Formula is the Building Block

You start with 1 euro that earns 10% interest for one year, giving an ending balance of 1.10
euro. For the second year, you start with 1.10 euro, which earns another year's worth of
interest, giving you an ending balance of 1.21 euro. And so on, for the entire eight-year
period until you end up with 2.14 euro.

Table 4.2



4
Because an annuity can be thought of as a series of lump sums, one might disregard the annuity formulas and treat
everything as lump sums, discounting or compounding each one separately, then summing the results.

51

Restating the Table 4.2 as an equation, it becomes

1*(1.10)*(1.10)*(1.10)*(1.10)*(1.10)*(1.10)*(1.10)*(1.10)=2.14

then simplifying, it becomes

1 * (1.10)
8
= 2.14

where i = 10%
and n = 8

It is generalized as (1+i)
n


Therefore, the expression (1+i)
n
is the basic building block of present value and future value
computations. Using the following equation, you solve for a FV by multiplying by the factor
(1+i)
n
and you solve for a PV by dividing by the factor (1+i)
n
:

FV = PV x (1+i)
n


The above applies to lump sums only. For annuities, the equation becomes slightly more
complex because 1 euro must be added to the balance at the beginning of each period. It is
never necessary to memorize the annuity equations because the table values give you the
results.


Time Value of Money

Now that you recognize that cash flows occurring at different times cannot be added
together without first adjusting for the time value of money, look at the examples in Table
4.3. Suppose there are three choices for receiving a 30,000 euro lump sum payment,
Scenarios A, B, or C. Which one is best, or are they the same, using an interest rate of
12%?
Table 4.3


There should be little doubt in your mind that Scenario B is best. Inspection of the data
makes this obvious. A rational person would not select A or C over B, because the eventual
value of the 30,000 euro in hand right now, at the end of the three years when all flows are
complete, will be worth more than the other two. In financial analyst's language, the present
value of B is greater than the present values of A and C. You can also glean the same
information from looking at the future values of the three scenarios. (Either present value
(at the initial date) or future value (at the terminal date) gives you the information needed;

52
showing both of them is redundant. They are both shown here to make the point.) The
30,000 euro given as totals are not relevant because they do not take the time value of
money into account. But, if the three scenarios were not so easy to evaluate by inspection,
what would you do? Let's look at two more sets of cash flows:

Which one is best, D or F? Each totals 30,000 euro. But, you already know that financial
analysts do not sum cash flows occurring at different times without first making adjustments
for the time value of money; the 30,000 euro given as totals are useless for decision
making. You can find out which flow is best by selecting the one with the highest present or
future value. As you can see, D is preferred over E.

Table 4.4 illustrates the by-hand calculation for Scenario D with annual cash flows and a
12% discount rate. The lump sum values are multiplied by the discount factor and
summed.

Table 4.4


To summarize, the purpose of the time value of money adjustment is to allow for the proper
comparison of cash flows occurring at different times. You often hear someone say, in
discussing a poorly conceived analysis, that apples and oranges are being compared. The
implication is that the conclusion is wrong because apples cannot be compared to oranges.
In financial analysis, summing euro amounts from different time periods is an
apples-to-oranges comparison; it is wrong. You cannot add (or subtract) today's euro to a
euro at any other time without first taking into account the fact that tomorrow's euro will be
today's euro plus compounded interest. Because today's euro is worth more than
tomorrow's euro, the euro must be adjusted to a common base in time before they can be
summed. Apples-to-oranges is converted to apples-to-apples by applying the present value
adjustment.

The most efficient way to portray the time value of money uses a spreadsheet. Cash flows
are spread over time. Table 4.5 is a generic spreadsheet. This sheet shows three
categories of cash flows and their annual totals. It portrays 150 invested, shown as a
negative because it is an outflow, which generates annual cash inflows of 40, 50, 60, and
70, followed by a final flow of 20, simulating an investment in a typical business project.
Notice that Column F is period zero, the starting point in time for the project. Period zero
shows a cash flow occurring today; period 1 shows a cash flow occurring one period later,
and so on. Cash flows occur at a moment in time, which can be confusing because they
are called flows. The present value of the flows is calculated in cell F24, discounting the
numbers in cells F23-J23. Note that the PV of the cash flow in F23 equals (150) because
the PV of todays cash flow is multiplied by (1+i)
0
, which is 1.


53
Table 4.5


You can see from Table 4.6 and 4.7 that this is the universal format for handling cash flows
of all kinds, summarizing them by calculating either their present or future values. Table 4.6
shows the cash flows in a bond contract. Table 4.7 shows the cash flows from an equity
investment. In both tables, the present value of the cash flows, at a discount rate of 12%,
shows the value of the bond or the stock to an investor expecting the cash flows as
portrayed.

Table 4.6


In Table 4.6, for a bond, the PV of the cash flows is 94. In Table 4.7, for a stock, the PV of
the cash flows is 114.

Table 4.7



Tables for Compounding & Discounting

There are four tables, where the i represents the interest rates and the n the time periods. If
the period is yearly, table values for i and n are on an annual basis already and require no
adjustment. If the period is semi-annual, the annual i must be halved and the annual n
doubled; there are twice as many semi-annual periods as annual periods, and the interest
rate is half as large. If the period is quarterly, the i is divided by four and the n is multiplied
by four, and so on for periods of any length.

54


TABLE A: PRESENT VALUE OF LUMP SUM

PV = FV x PVIF
i,n

where the table factor, PVIF
i,n

is 1 (1+ i)
n


This equation is used by plugging in three knowns (n, i, and FV) and solving for the
unknown (PV). Note that the numerical values of all table factors are less than one. Also
note that Tables A and C are reciprocals.








55

TABLE B: PRESENT VALUE OF ANNUITY


PVA = PERIODIC PAYMENT x PVIFA
i,n



The table factor PVIFA
i,n



The equation is used by plugging in three knowns (n, i, pmt) and solving for the unknown
(PVA).








56
TABLE C: FUTURE VALUE OF LUMP SUM


FV = PV x FVIF
i,n


where (1+i)
n
is the table factor FVIF
i,n


This equation is used by plugging in three knowns (n, i, PV) and solving for the unknown
(FV). Not that all table factors are greater than one. Also note that Tables A and C are
reciprocals. Table C factors are also called growth factors or compound annual growth rate
(CAG).





57
TABLE D: FUTURE VALUE OF ANNUITY


FVA = PERIODIC PAYMENT x FVIFA
i,n


The table factor FVIFA
i,n


This equation is used by plugging in three knowns (n, i, pmt) and solving for the unknown
(FVA).






58
Automating the Calculations Using HandyCalc

A useful generalization is made from examining these calculations, which will help you to
hone your understanding of financial arithmetic. You see that there are four possible
calculations. For the lump sum calculations there are four data items; you know three of
them (the givens) and solve for the fourth (the result).

For the annuity calculations, there are five data items; you know four of them (the givens)
and solve for the fifth (the result). You plug in the knowns and solve for the unknown. The
discounting and compounding tables previously shown have the number of periods in the
first column, undefined as to the length of the period. HandyCalc.xls allows you to refine the
time measure by specifying the number of periods per year; that is why you enter one more
known value in timecalc.xls than in the table calculations you do by hand.

The tables in this section are in the HandyCalc tab in the Morgan-Green Template Set. It
performs 9 kinds of calculations:
1. Future value of a lump sum - solving for FV
2. Present value of a lump sum - solving for PV
3. Future value of an annuity - solving for FV
4. Present value of an annuity - solving for PV
5. Amount of mortgage payment - solving for periodic payment
6. Periodic deposit needed to accumulate a given sum - solving for periodic payment
7. Growth rate for given beginning and ending values of a lump sum - solving for
interest rate
8. Years needed to grow a lump sum to a given ending value - solving for number of
periods
9. Years needed to grow period payments to a given ending value - solving for
number of periods.

Table 4.8, reading from left to right, does calculations for
future value of lump sum (Table C in the text)
present value of a lump sum (Table A)
future value of annuity (Table D)
present value of an annuity (Table B)

The four calculations automate the same calculations you could do by hand using the
Tables A-D.

Enter the givens and the computer instantly provides the result. Interest rates are always
entered as decimals6% goes in as .06. Each box is for a separate type of calculation.

Select the type of computation you want, using columns B-D. Numbers are entered in blue-
colored bold cells. The bottom line, RESULT, is the answer. Note that the given for lump
sums is a Amount expressed as a lump sum and the given for an annuity is a periodic
payment. An input for periods per year automatically annualizes the results. If the flows are
annual, enter 1; if quarterly, enter 4; if monthly, enter 12. If you are not sure about the
match up between n and I, review the text again. The NA appears in the first two
calculations because there is no periodic payment involved in a lump sum calculation. NA

59
appears in the last two calculations because no lump sum is involved in an annuity
calculation.
FV of Lump Sum compounds a PV at the specified interest rate for the specified
period of time
PV of Lump Sum discounts a FV at a specified interest rate for the specified period
of time
FV of Annuity compounds a series of periodic payments into a FV accumulation at
a specified interest rate for the specified period of time
PV of Annuity gives the lump sum PV equivalent of a series of periodic payments
at a specified interest rate for the specified period of time

Table 4.8



Table 4.9 is a variation on theme. Here the answer is the payment required to achieve a
known PV or FV rather than the PV or FV. As in Table 4.8, the numbers in bold are
entered into the template (you choose whether to use one or both of the two columns, B
and/or C, leaving the other blank). The bottom line, RESULT, is the answer,
Mortgage Payment is computed based on the periods, interest rate, and amount of
the loan. Note that the amount of a loan is a present value. It can be used to figure
the payment on auto loans or home mortgages. By varying the periods per year, it
will figure monthly, quarterly, semi-annual, or annual payments.
Deposit to Accumulate is a variation of the future value of an annuity calculation.
The Amount is what you want to accumulate after a known number of periods in a
retirement fund, for example. The answer is the periodic payment required to
accumulate that sum.

Table 4.9


The third panel offers further variations. Here the givens list six data items, but not all of
them are used for each calculation. If you go back to Panel One for a quick look, notice that

60
the givens for all four calculations are the same all the way across, and the result is either a
PV or FV, depending on what type of calculation it is. If you go back to Panel Two, again
the givens are the same all the way across, and the result is a periodic payment. But, in
Panel Three, the result for the first calculation is a percentage interest rate (rate of return),
and in the second and third it is a number of periods.
Lump Sum Growth Rate, computes the rate of return when the beginning and
ending euro amounts are known. This is useful when you have a known PV, FV
and number of years and need to know what the growth rate is. Since the euro
amounts are lump sums, the periodic payment is NA. For example, when you have
50 euro and need 60 euro in one year. A 20% rate of return is needed to grow the
beginning amount to the ending amount over the specified time period. Since the
euro amounts are lump sums, the periodic payment is NA.
Years to Grow Lump Sum gives you the number of periods it takes to go from a
known PV to a known FV with a known interest rate.
Years to Grow Annuity gives youre the number of periods it takes to grow a
series of periodic payments at a known interest rate into a known FV.

Table 4.10




61
CHAPTER 5
CAPITAL BUDGETING & COST OF CAPITAL

This chapter is about the GREEN blocks in the IS/BS Model the property, plant and
equipment on the balance sheet, and the resulting expenses on the income statement
as property, plant and equipment is operated to produce goods and services for
customers. Also called cost-benefit analysis, sometimes called project analysis, project
valuation or investment decision, capital budgeting is a procedure to make sure the
investment in plant, property and equipment and the investment in working capital, is
justified by the prospective rate of return on the project.




Overview of Capital Budgeting

Introduction

Capital budgeting, investment analysis, project valuation, project analysis and cost-benefit
analysis are interchangeable synonyms. The analysis assists in deciding if proposed
projects are justified when comparing the cash flows invested in them to the cash flows
they generate. These are before-the-fact decisions where financial managers crunch the
numbers on project proposals coming from operating managers. Projects that dont pay
their own way will drain the resources of the business and destroy its value. Therefore,
these decisions are crucial for operating managers who want to grow their businesses, and
not grow them into the ground by investing more in a project than it is worth.

Learning Objectives:
1. Understand creation and destruction of shareholder value that explains why
capital budgeting is so important to managers
2. Understand the importance of either green lighting or red lighting a project
backed by a sensible analysis

62
3. Appreciate the differences between operating cash flows and capital cash flows,
that operating cash flows come from the income statement (revenue minus
operating expense) and capital cash flows come from the balance sheet
(changes net working capital and capital expenditures for property, plant and
equipment)
4. Know how to apply the step-by-step capital budgeting methodology

Creation and destruction of shareholder value why capital budgeting is so
important

The combined cash flows for all the projects in the business are the basis for the businesss
value. Simply stated, the value of a business is the present value of its free cash flows. If
the cash flows for all projects in the business have satisfactory rates of return, which
allowed each one of them to be accepted (green-lighted), then the aggregate cash flows for
all the projects will provide a satisfactory overall rate of return for the whole business. With
satisfactory rates of return, the value of the business is maintained or increased.
Conversely, with unsatisfactory rates of return, the value of the business declines. Capital
budgeting is vitally important because it offers an advance look, before the investment is
made, into whether or not a proposed project is value creating (green light) or value
destroying (red light). As this chapter unfolds, you will learn how to use the classic
methodology of capital budgeting, perhaps the most widely used and abused tool of
financial analysis.



Look at the two sets of photos to get yourself thinking about the choices a business
makes about what kind of property, plant and equipment it invests its money in. The
paint spraying operation in the first set of photos can be simple or high tech. Simple
implies low investment in fixed assets on the balance sheet and low (not always) fixed
costs on the income statement. If you have a dozen workers painting your products with
a spray can, investment is low. Fixed cost is low because you can lay off the workers if
sales slow down, making them a variable cost rather than a fixed cost. The robotic
painter requires a high investment outlay and generates high fixed cost since you cant
lay it off very easily if demand for the product drops. But, it paints much more efficiently
and faster than the human worker pressing a button on a spray can.


63




The second set of photos repeats the same point. The assembly room operation in the
first photo has people but no machines. In the second photo, its just machines but no
people. It doesnt cost much to set up the first room, under $5,000 for some second-
hand tables, chairs, and shelving. The second room could cost hundreds of thousands if
not millions of dollars. Which approach is best, low tech or high tech, given the same
production volume? Thats the job of capital budgeting to identify the cash flows
involved before the investment is made, to help you make the decide which project is
best. If the analysis is run to choose between the high tech vs. low tech factor, the
analysis process is called a choice between mutually exclusive opportunities; it identifies
which project is better than the other. Sometimes the capital budgeting process looks at
only one project; here the rate of return on the project must be high enough to pass
muster.





64

The classic capital budgeting process has three steps:
1. identify the relevant incremental cash flows for the project
2. calculate a discount rate, also called weighted average cost of capital, k
wacc

3. calculate the decision criteria: net present value (NPV), profitability index (PI),
internal rate of return (IRR), and payback period (PP).

Step 1: Identify Relevant Incremental Cash Flows

Relevant incremental cash flows are divided in two categories.

1. First, there are two categories of capital flows, the increments in the balance sheet
accounts attributable to the proposed project:
a. Investment in fixed assets - plant, property and equipment (PPE)
b. investment in net working capital - the net of increases in accounts
receivable plus inventory minus accounts payable (NWC).

Investment in fixed assets speaks for itself because a new project may require
increased investment in machines, buildings, and/or land. Less obvious but equally
important is that net working capital also increases, because the increased volume
of business means new revenue is generated by the new project. As revenue rises,
net working capital rises along with it.

2. Second are operating flows, the increments in the income statement resulting in
changes in revenue and expenses created by the new project.

The with-without principle. Think of two sets of financial statements for a company.
One set includes the transactions for the new project being proposed; the other set is
exactly the same except it does not include anything related to the proposed new
project. The capital budgeting process captures the difference between the two sets of
financial statements, the first set with the project the second set without it, i.e., the
increments referred to in the paragraph above. The process deals only with incremental
cash flows, cash flows that are generated by the proposed project, those cash flows that
would not occur without it.

Incremental cash flows not accounting accruals, not allocations of existing
costs. We are measuring the flow of actual cash money not accounting accruals, not
what accountants put into accrual-based income statements and balance sheets. Think
of a kids lemonade stand. She uses a cigar box for the money, starting with $25 from
her grandfather. To buy supplies, she takes cash out of the box. Cash received from
selling lemonade goes into the box. Pure and simple, its based on cash basis only. The
same idea applies to capital budgeting analysis. Cash flows are not relevant in this
methodology if they dont go into or come out of the cigar box representing the project.


65


Some general rules for identifying relevant incremental cash flows are:
Sunk costs are not incremental costs for the project under analysis because the
money is already spent. It cant be unspent if the capital budgeting process signals
a red light. (Research and development costs are one possible exception to the
sunk cost rule. In the pharmaceuticals industry, where research costs are huge,
adaptations to standard capital budgeting procedures are made.)
Allocated fixed costs such as overhead are not incremental costs because the
money is already spent. Allocations are a thorny issue that causes lots of
disagreements between operating managers and financial managers, especially in
the face of a rule that charges all projects a flat percentage rate for corporate
overhead.
Erosion of sales of an old product line caused by a new product line is a relevant
incremental cost and must be netted out of the proposed projects revenue forecast.
When the proposed project uses excess capacity, i.e., plant and machine capacity
is available without investing in new PPE for the proposed project, the existing PPE
is not an incremental cash flow. It already exists and does not have to be
repurchased. Nevertheless, managers may make territorial judgments, believing
that the new project is getting a free ride in their plant if a charge for existing
capacity does not appear in the new projects proposal. The best way to think this
through is to imagine an organization chart for the company. A plant manager may
think the plant is his, but in reality it belongs to the shareholders. Think of capital
budgeting decisions as being vetted at the board of directors level, or at the
corporate CFO level, not at the level of plant managers or product managers. The
broad viewpoint of the whole company is the relevant viewpoint, not the narrow
viewpoint of one product line or profit center. Managers can confuse before-the-fact
capital budgeting metrics with after-the-fact performance metrics, often because of
poorly designed and communicated bonus plans. Always remember the purpose of
capital budgeting methodology to make the green-light or red-light decision before
an investment is made. It is not a cost accounting scheme or a management
performance program.
Depreciation expense is triggered by the investment outlay for property, plant and
equipment. Never forget to keep this connection in mind it links the balance sheet
item with the income statement item. It is a tax-deductible expense, but a non-cash
charge. Therefore, it is deducted to calculate income before tax, then added back to
calculate after-tax cash flow.
Interest expense is not a relevant cash flow in capital budgeting because the
process applies the cost of capital as the discount rate. Only revenues and
operating costs are considered. Including interest expense amounts to double
counting. If a deduction is made for interest expense, and then the cash flows are
discounted, this is tantamount to counting the financing costs twice.

66

Generic Capital Budgeting Template

1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
32
33
34
35
36
37
38
39
40
41
42
43
44
45
46
47
48
49
50
51
52
A B C D E F G
Year 0 1 2 3 4 5
Units sold 0.0 0.0 0.0 0.0 0.0
Sales price per unit 0.0 0.0 0.0 0.0 0.0
Sales revenue 0.0 0.0 0.0 0.0 0.0
Less: variable cost of good sold 0.0 0.0 0.0 0.0 0.0
Less: fixed cost of goods sold 0.0 0.0 0.0 0.0 0.0
Less: variable GS&A expense 0.0 0.0 0.0 0.0 0.0
Less: fixed GS&A expense 0.0 0.0 0.0 0.0 0.0
Less: depreciation 1.0 1.0 1.0 1.0 1.0
Equals: total operating expense 1.0 1.0 1.0 1.0 1.0
Equals: EBIT -1.0 -1.0 -1.0 -1.0 -1.0
Income tax rate & income tax 0% 0.0 0.0 0.0 0.0 0.0
Operating cash flow:
EBIT -1.0 -1.0 -1.0 -1.0 -1.0
Minus: Taxes 0.0 0.0 0.0 0.0 0.0
Plus: Depreciation 1.0 1.0 1.0 1.0 1.0
Equals: Operating cash flows 0.0 0.0 0.0 0.0 0.0
Change in Net Working Capital:
Revenue 0.0 0.0 0.0 0.0 0.0
Cost of goods sold 0.0 #DIV/0! #DIV/0! #DIV/0! #DIV/0!
Receivables (enter days in Column B) 0 0.0 0.0 0.0 0.0 0.0
Inventory (enter days in Column B) 0 0.0 #DIV/0! #DIV/0! #DIV/0! #DIV/0!
Payables (enter days in Column B) 30 0.0 #DIV/0! #DIV/0! #DIV/0! #DIV/0!
Net working capital needs 0.0 #DIV/0! #DIV/0! #DIV/0! #DIV/0!
Liquidation of working capital 1.0
Investment in working capital 0.0 #DIV/0! #DIV/0! #DIV/0! #DIV/0!
Free cash flow:
Operating cash flow 0.0 0.0 0.0 0.0 0.0
Minus: Invesment in net working capital 0.0 #DIV/0! #DIV/0! #DIV/0! #DIV/0!
Minus: Investment in PPE (CapEx) 0.0 0.0 0.0 0.0 0.0 0.0
Plus: Salvage value 0.0
Free cash flow 0.0 0.0 #DIV/0! #DIV/0! #DIV/0! #DIV/0!
Cumulative free cash flow 0.0 0.0 #DIV/0! #DIV/0! #DIV/0! #DIV/0!
Discount rate (K-wacc) 0%
Net Present Value (NPV) #DIV/0!
Profitability Index (PI) #DIV/0!
Internal Rate of Return (IRR) #VALUE!
Payback Period inspection of cumulative FCF - row 45
SECTIONS II AND III, IN ADDITION TO THE CHANGE IN CAPITAL SPENDING
SECTION V. CALCULATE DECISION CRITERIA USING FREE CASH FLOW
SECTION I. CALCULATE THE CHANGE IN EBIT, TAXES, AND DEPRECIATION (THIS BECOMES
AN INPUT IN THE CALCULATION OF OPERATING CASH FLOWS IN SECTION II)
enter data in blue-colored cells
SECTION II. CALCULATE OPERATING CASH FLOW (THIS BECOMES AN INPUT IN THE
CALCULATION OF FREE CASH FLOW IN SECTION IV)
SECTION III. CALCULATE THE NET WORKING CAPITAL (THIS BECOMES AN INPUT IN THE
CALCULATION OF FREE CASH FLOWS IN SECTION IV)
SECTION IV. CALCULATE FREE CASH FLOW (USING INFORMATION CALCULATED IN

67
Above is a Generic Capital Budgeting Template organized to enhance your learning of
the steps involved in the capital budgeting process. Find a working version in Template
Set.xls. Here is a step-by-step run-through of the template:

1. Section I contains income statement entries. Enter data in the blue-colored
cells. Data comes from the proposed projects income statement forecast.
Make sure you are comfortable with this there is nothing unique or
mysterious about where the data comes from - engineering estimates, market
studies, focus groups, historical data, and sometimes, mere guestimates.
Recall the financial statement forecast discussed in Chapter 3, where income
statements and balance sheets were projected, for the whole business. Here,
income statements and balance sheets are projected only for the project
under analysis.
2. Rows 5 & 6 are the two main components of revenue, unit volume and price
per unit, multiplied together to get row 7, revenue.
3. Rows 8 & 9 break cost of goods sold into variable and fixed components. If
the fixed vs. variable cost breakdown is not known, use only one row.
Assuming that cost of goods sold is 100% variable cost, if it really has a fixed
cost component, biases the analysis. It is rare, however, to find fixed vs.
variable cost breakdowns in published data, so use the numbers you have,
understanding their limitations.
4. Rows 10 & 11 break selling, general and administrative expenses into
variable and fixed components. If the breakdown is not known, as discussed
in the point above, use only one row.
5. Row 12 shows depreciation expense. Sometimes depreciation expense is
included in costs of goods sold, even though its best to identify it separately
on row 12. It is based on the investment in plant, property and equipment in
row 42. If depreciation as a separate item is not provided, then leave this row
blank, knowing that free cash flow will be underestimated because no
depreciation is added back.
6. Row 13 calculates the sum of expenses in rows 8-12.
7. Row 14 subtracts row 13 total operating expenses from row 7 revenue to
calculate EBIT.
8. Row 15 uses the income tax rate in cell B15 to calculate the income tax on
EBIT. Note that no interest expense is considered in this template. Only
operating cash flows are considered in this analysis. Interest expense, a
financial cash flow, is brought into the analysis by using the k-wacc, as
explained above.
9. Section II has no input cells and summarizes the income statement rows of
Section I. It calculates row 23 operating cash flows by subtracting taxes from
EBIT and adding back depreciation expense, a non-cash charge subtracted
in Section I to arrive at total operating expense. Depreciation expense was
deducted as an expense, but unlike the other expenses where cash was
paid, no cash was paid for depreciation, so it must be added back after it was
subtracted out to get the taxable income number so taxes can be calculated.
10. Section III contains balance sheet entries. Rows 28 and 29 are memo entries
drawn from cells in Section I - they are needed to calculate row 30
receivables, row 31 inventory, and row 32 payables. Enter the days of
receivables, inventories, and payables in rows B30, B31 and B32 as they are
established by the working capital policy of the business.

68
11. Row 30 receivables is calculated by multiplying the days of revenues in
receivables (collection period) by revenues per day, annual revenues divided
by 365 days. Receivables is based on revenues.
12. Row 31 inventory is calculated by multiplying the days of inventory by cost of
goods sold per day, annual cost of goods sold divided by 365. Inventory is
based on cost of goods sold, not revenues, because cost of goods sold is the
proxy for production cost.
13. Row 32 payables is calculated by multiplying the days in payables (payment
period) by cost of goods sold divided by 365, assuming that cost of goods
sold is a proxy for purchases of production inputs from suppliers.
14. Row 33 sums the total net working capital for each year, receivables plus
inventory minus payables, that is required for this project. The end-of-year net
working capital dollar amounts represent the cumulative total of each annual
investment in NWC. Each annual investment represents the year-by-year
incremental investment in NWC. Point 16 clarifies it. This is a complex
calculation, often mixed up and misstated.
15. Row 34 assumes that the total investment in net working capital can be
recovered at the end of the project. Therefore, cell G34 estimates a cash
inflow, which may or may not actually occur. If receivables and inventory are
high quality, it is likely that the cash will be received by collecting all the
receivables and selling the entire inventory at the end of the projects life. If
they are low quality, perhaps only 50% or less, even 0%, might be collected.
The best you can do for is to make a judgment about it.
16. Row 35 calculates the incremental investment in net working capital that must
be made to support this project. C35 is the initial net working capital
investment for the first year of the projects life, building the working capital
from scratch. Thereafter, driven by changes in revenue, net working capital
changes also. The relevant cash flow for the capital budgeting analysis is not
total net working capital in row 33, but the incremental change from year-to-
year in row 35.

This concept is hard to grasp until you realize what is going on. With revenue
constant from year to year, net working capital does not grow. Yes, there is a
steady flow of transactions in and out of receivables, inventory and payables
but - they stay at the dollar same level when the amount of revenue is
constant, and management policy on the number of days in receivables,
inventory, and payables also stays the same. When revenue increases, NWC
increases: when revenue decreases, NWC decreases (spontaneous
changes). Changing the number of days also causes NWC changes, but
such changes are policy changes, not spontaneous changes. Think of
spontaneous changes as those not requiring action by managers they
happen automatically. A change in the number of days is a policy change,
instigated by a manager, not automatic.

Because capital budgeting analysis must capture the incremental cash
flows each year, the relevant NWC cash flows are the year-to-year
differences between the cumulative year-end NWC balances on row 14.

Think of each working capital account as a faucet. Opening the receivables
and/or inventory faucets to increase the flow is tantamount to offering a
longer collection period - more days, or holding a larger inventory - more

69
days. For payables, opening the faucet to increase the flow means a longer
payment period - more days, taking on more credit from suppliers. The
analogy of faucets explains that working capital items are easily adjustable
because cash flows go in and out of these accounts every day; the settings
on faucets can be adjusted easily. If too much or too little investment in NWC
is made, the remedy is easy to implement. Conversely, for plant, property and
equipment, fixed assets, if too much is invested, in brick and mortar and
machines, adjustments are slow and costly, because they are one-time
transactions as opposed to the day-in day-out transactions in working capital
accounts.

A panel from the Generic Capital Budgeting Template illustrates the very
important points of this discussion about NWC. The spreadsheet rows in the
first panel below show constant revenue in row 28, the same for cost of
goods sold in row 29 - the business is operating in a steady state. With the
days of receivables, inventory, and payables in B30.32, each working capital
item is calculated in rows 30, 31, and 32, then summed (minus for payables)
in row 33. Each number in row 33 shows the cumulative NWC at the end of
each of the five years forecasted. They are all the same, 83.7, because
revenue was constant, cost of goods sold was constant, and the days were
constant. Therefore, investment in NWC occurs only once in this example, in
the first year, C35. For the other years, NWC does not increase or decrease,
so each subsequent years investment in NWC is zero no change in
revenue or days, no change in NWC.

Now look at a spreadsheet where revenue increases each year, in the
second panel. Here, revenue and cost of goods sold increases, causing each
component of NWC to increase along with it. Instead of 83.7 in all cells of row
33 in the top panel, this panel shows increasing NWC totals for each year.
The increments in row 35 are the differences year-by-year. These
differences, the increments, are what you want to capture for the capital
budgeting analysis.

28
29
30
31
32
33
34
35
A B C D E F G
Revenue 1000.0 1000.0 1000.0 1000.0 1000.0
Cost of goods sold 22.0 22.0 22.0 22.0 22.0
Receivables (enter days in Column B) 30 82.2 82.2 82.2 82.2 82.2
Inventory (enter days in Column B) 50 3.0 3.0 3.0 3.0 3.0
Payables (enter days in Column B) 25 1.5 1.5 1.5 1.5 1.5
Net working capital needs 83.7 83.7 83.7 83.7 83.7
Liquidation of working capital 0.0
Investment in working capital 83.7 0.0 0.0 0.0 0.0

70
17. Section IV completes Step 1 of the capital budgeting template by compiling
results from Sections II and III and entering the investment in fixed assets
(property, plant and equipment PPE also called Capital Expenditures) in
cell B42. These numbers combine to calculate FREE CASH FLOW (always
make sure that the + or signs are as you intend mistakes here are
commonly found errors in capital budgeting. These FREE CASH FLOW
numbers, for each year of the forecast, is the objective of Step 1, i.e.,
determining the relevant incremental cash flows. Row 40 is drawn from row
23, row 41 drawn from row 35 is subtracted, row 42 capital expenditure is
deducted, and G43 salvage value if any is added. The result is B44. (FREE
CASH FLOW is called Net After Tax Cash Flow (NATCF) by some financial
analysts.)


Step 2: Calculate the Discount Rate
Weighted Average Cost of Capital (k
wacc
)

A discount rate is needed before you can perform the present value calculations in
Section IV of the Generic Capital Budgeting Template. This topic explains cost of capital
the discount rate used in capital budgeting calculations. See how the IS/BS Diagram
depicts cost of debt and cost of equity, the two components of cost of capital, also
known as k
wacc
. Also, see how the Flow Diagram in the top-left corner depicts the steps
in financial analysis. The k
wacc
calculation step comes before capital budgeting, because
the discount rate is an input to the capital budgeting analysis.



INCOME STATEMENT BALANCE SHEET WORKING CAPITAL
Revenue ASSETS LIABILITIES AND EQUITY changes spontaneously with revenue
Cost of sales Current assets Current liabilities ?what levels of ca, cl, s-t loans?
Gross profit Cash Trade payables CAPITAL BUDGETING
Other operating income Investments Other accruals ?which projects to accept?
Other operating expenses Trade receivables Tax liabilities FINANCING
Total cost and expenses Inventories Short-term loans, leases ?how much debt capacity?
Operating profit (EBIT) Non-current assets Non-current liabilities
Interest, finance costs Property, plant & equipment Loans, debt, leases due after 1 year
Profit before tax Investment property Retirement benefit obligation COST OF DEBT
Income tax Goodwill Deferred tax liabilities
Net profit after tax Total non-current liabilities
Dividends K-WACC
Reinvested in the business Stockholder's equity (Net worth)
Preferred stock
OPERATING LEVERAGE Common stock COST OF EQUITY
Additional paid-in-capital
FINANCIAL LEVERAGE Retained earnings VALUATION
CASH FLOW
Total assets Total liabilities & equity COST OF CAPITAL
28
29
30
31
32
33
34
35
A B C D E F G
Revenue 1000.0 1100.0 1200.0 1300.0 1400.0
Cost of goods sold 22.0 24.2 26.4 28.6 30.8
Receivables (enter days in Column B) 30 82.2 90.4 98.6 106.8 115.1
Inventory (enter days in Column B) 50 3.0 3.3 3.6 3.9 4.2
Payables (enter days in Column B) 25 1.5 1.7 1.8 2.0 2.1
Net working capital needs 83.7 92.1 100.4 108.8 117.2
Liquidation of working capital 0.0
Investment in working capital 83.7 8.4 8.4 8.4 8.4

71

Learning Objectives:
1. Understand why cost of capital (also known as k
wacc
, the investors required
rate of return) is the discount rate used in capital budgeting and valuation
calculations
2. Know that the cost of capital percentage is directly related to the riskiness
inherent in the cash flows under analysis - the more the cash flows are likely
to vary, the higher the cost of capital
3. Know how to calculate cost of debt, k
d

4. Know how to calculate cost of equity, k
e

5. Know how to combine k
d
and k
e
as a weighted average to get k
wacc

6. Appreciate the danger of excessive risk adjustment
7. Know how to use the cost of capital template

Cost of debt is (somewhat) concrete



The cost of debt concept may not be quite as concrete and palpable as the sidewalk in
the picture above, but it is close. Cost of capital is not be animal, vegetable or mineral,
but its two components are observable:
1. Interest rate on borrowed money.
2. Income tax rate.

These rates are relatively unambiguous because a business knows the rate of interest it
pays on borrowed money and it knows its income tax rate.

The bond certificate below has the rate of interest (the coupon rate) printed on it. A loan
agreement includes an interest rate as part of the contract.

72



This tax rate schedule shows the rate charged to corporations in the United States.


Therefore, calculating cost of debt is fairly straightforward:

COST OF DEBT = INTEREST RATE * (1 - TAX RATE), using the notation k
d


Cost of equity not so tangible

Calculating cost of equity is sometimes a challenge. It is very hard to get exactly right,
because its components are ambiguous compared to the components for cost of debt.
They are not as close to animal, vegetable or mineral as cost of debt is.


73
Think of cost of equity as a ghost lurking in a cloud. Cost of debt? I can see and feel it
a concrete sidewalk. Cost of equity? I cant see it. I have to conjure it up. Its a ghost in a
cloud.




CAPM: COST OF EQUITY = RISK-FREE-RATE + (BETA x RISK PREMIUM)

Tap a finance major on the shoulder at any time, any where, day or night, ask for the
Capital Asset Pricing Model (CAPM) equation, as above, and you should get a quick,
correct response. It is vita and universal. Even if you are not a finance major, learn it.
You will appreciate the elegance of its logic.

The components of cost of equity are
Risk-free rate
Beta
Equity risk premium (ERP)
5



5
According to Professor Pablo Fernandez, the average Equity Risk Premium (ERP) used by analysts in
2009 in the USA (5.1%) was similar to the one used by their colleagues in Europe (5.0%). But the average
ERP used by companies in the USA (5.3%) was smaller than the one used by companies in Europe (5.7%),
and UK (5.6%).The dispersion of the analysts ERP used was high, but lower than the one of the professors:
the average range of ERP used by analysts (companies) for the same country was 5.7% (4.1%) and the
average standard deviation was 1.7% (1.2%). These statistics were 7.4% and 2.4% for the professors. He
reviewed 100 finance and valuation textbooks published between 1979 and 2008 (Brealey, Myers,
Copeland, Damodaran, Merton, Ross, Bruner, Bodie, Penman, Weston, Arzac...) and found that their
recommendations regarding the equity premium range from 3% to 10%, and that several books use different
equity premia in different pages. Some confusion arises from not distinguishing among the four concepts
that the word equity premium designates: Historical equity premium, Expected equity premium, Required
equity premium and Implied equity premium. Finance professors should clarify the different concepts of
equity premium and convey a clearer message about their sensible magnitudes.


74
Which risk-free rate to choose, 90-day, 180-day, 1-year, 5-year, 10-year, 20-year, 30-
year? Match the maturity of the risk-free security to the time horizon of the cash flows
you are evaluating.

The role for Beta is to tailor the cost of equity (a rate of return required by the
stockholder) to the risk of a particular company. A popular finance writer says insert a
fudge factor known as the companys equity beta He is correct in calling the beta a
fudge factor, because it is so inexact. It is a handicapper to estimate the risk profile of
the company whose cost of equity is being estimated.

Which equity risk premium to choose? Depending on the time period and data series
you choose, or the financial analyst you talk to, it ranges from 3% to 10%. Risk premia
are computed by taking the difference between the annual rate of return on a stock
market index such as the S&P 500 and the risk-free rate (the yield on a government
security). To the extent that the choice of risk premium for this calculation is inexact or
arbitrary, the resulting cost of equity is also inexact and arbitrary. Cost of equity is very
hard to observe concretely and is full of ambiguity.

Nevertheless, we calculate it as:

COST OF EQUITY = RISK-FREE RATE + [BETA x EQUITY RISK PREMIUM],

using the notation k
e
, the CAPM equation, one of the most famous in finance, for
which William Sharpe earned his Nobel Prize.

The hardest thing to absorb about cost of equity is this: it is truly a cost. You might think
that if a business has no obligation to pay dividends, equity has no cost. If it does pay
dividends, it can cut or eliminate them at any time. Therefore, since there is no need to
pay anything to shareholders, you assume there is no cost connected to equity. If you
think that, you are wrong about a foundation concept in finance. A business must
satisfy its shareholders by providing a rate of return on their investment. Please, work
hard on seeing cost of equity as the required rate of return that shareholders demand.
Forgive me for repeating it so many times, but many smart people get it backwards,
believing that equity costs a company less because it does not have to pay interest on
stock like it does on bonds.

In the chart below on the left, you see the calculation that generates Beta, the slope of
the regression line in an ordinary least squares (OLS) regression.



The beta coefficient is the slope of a least squares regression line.
The independent variable is the rate of return on a market index of equity shares.
The dependent variable is the rate of return on the companys equity shares.
Matched pairs of data are generally used covering 60 monthly periods.
RETURN ON COMPANY SHARE return
Security Market Line (SML)
13.0%
slope of the line is Beta coefficient undervalued
10%
RETURN ON MARKET INDEX
market portfolio Beta = 1 overvalued
market portfolio intercept = 0 5.0%
risk-free rate
OLS Regression - Characteristic Line 1.0 risk (Beta)
Expected Return = Risk-Free Rate + (Beta x Risk Premium)

75

Therefore, the beta is an index measuring the volatility of the companys shares relative
to the volatility of the equity market index, providing a measure of risk specific to the
company under analysis. A Beta of 1.11 means that the rate of return on a stock is 1.11
times the rate of return on the market index, for the 60-month period over which data is
drawn. Stated another way, if the market return is x%, the rate of return for a stock is
expected to be 1.11 times x%, because of the risk that is specific to this company.

Do not to confuse the OLS diagram on the left, displaying the characteristic line, with
the diagram on the right displaying the security market line. The market line shows the
relationship between risk and return, always plotting risk on the horizontal axis, with the
normal line moving upward to the right because more risk requires more return. Riskier
bonds have higher YTMs than less risky ones. Stocks have higher rates of return than
bonds.
The intercept of the market line with the vertical axis shows the risk-free rate.
The characteristic line is the result of an OLS regression analysis.
The slope of the characteristic line is the Beta of the stock under analysis.
The Beta measures the volatility of the stocks return compared with the volatility
of the markets return.

Putting it all together calculating weighted average cost of capital, k
wacc


A. Basic K-
wacc
, Calculation of Weighted Average Cost of Capital

The template below calculates K-
wacc
using this equation (notice the formulas and
equations in Columns C & D they are explained in this section):

K-WACC = [COST OF DEBT x % OF DEBT] + [COST OF EQUITY x % OF EQUITY]



The 10.90% weighed average cost of capital figure computed in cell B17 of table above has
three components:
The cost of debt financing
The cost of equity financing
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
A B C D
BASIC: Formula Equation
COST OF DEBT:
Coupon Rate 7.00% given
Marginal Tax Rate 15.6% given
Cost of Debt 5.91% b5*(1-b6) k-d = I x (1- t)
weight of debt 50% See Table 5.4 d d+e
COST OF EQUITY:
Risk-Free Rate 5.50% given
Risk Premium 8.00% given R-m - R-f
Beta 1.30 given
Cost of Equity 15.90% b11+(b13*b12) k-e = R-f + [ x (R-m - R-f)]
weight of equity 50% 1-b8 e d+e
Weighted-Average Cost of Capital 10.90% (b8*b7)+(b15*b14) (k-d x wt-d)+(k-e x wt-e)

76
The proportion of debt and the proportion of equity used in financing the business,
totaling 100%

1. Rows 4-8 compute the cost of debt. It is a measure of the interest rate on loans
and debt on an after-tax basis, since financing cost is tax deductible.
2. B5 is the coupon rate on debt.
3. B6 is the marginal tax rate.
4. B7 calculates the cost of debt at 5.91%, B5 x (1-B6). The term (1-B6)
represents 100% minus the tax rate. Each dollar of interest does not cost the
company one full dollar because interest expense is tax deductible. With a tax
rate of 15.6%, 15.6 cents of each interest dollar is subsidized by the tax
authority. The after-tax cost is therefore 100% minus 15.6%, or 84.4%. (1-B6) =
84.4%.
5. The proportion debt financing to total financing is in B8, 50%. The rounded 50%
proportion of debt consists of non-current leases (0.9) and loans (413.1), and
that the 50% proportion of equity consists of share capital (120), capital
reserves (32.9), and accumulated profits (259.7). Therefore, the debt proportion
is 0.9+413.1 divided by 0.9+413.1+120+32.9+259.7, or 414.0/826.6, which is
rounded to 50%. If the debt proportion is 50%, the equity proportion in B15 is 1
minus debt proportion (1-.50), which is 50%.
6. Rows 10 through 14 compute the cost of equity. It is an estimate of the rate of
return required by equity investors in the company. A proxy for this is given by
an equation universally known in modern finance, the Capital Asset Pricing
Model (CAPM), a model holding that rate of return must always be proportional
to risk.
7. Start with the risk-free rate in cell B11 (the rate of return on a default-proof
government security).
8. Add an equity risk premium to reflect the additional risk assumed by an equity
investor holding a diversified portfolio such as the EAFE Index or the S&P 500
Index. Equity risk premia range from 4% to 8% historically, with 8% arbitrarily
chosen for this analysis as in cell B12, the high end of the historical range. But,
these measures refer to the capital market in general, not the specific risk of a
company.
9. A parameter known as Beta brings the business and financial risk into the
model, set at 1.30 shown in cell B13.
10. B14 calculates the cost of equity using the CAPM equation in the box below.
11. B15 shows the weight of equity, the equity proportion of financing to total
financing, discussed in point 5 above. The equity weight is 100% minus the debt
weight.
12. B17 calculates the weighted average of the two components of cost of capital,
cost of debt and cost of equity combined, 10.90%, the result we are seeking. It
is the required rate of return that the capital market expects the company to
generate on its projects, the discount rate we use in the Generic Capital
Budgeting Model.

CAPM = Risk free rate + {Beta x Equity Risk Premium}


77
B. Advanced K-
wacc
, Calculation of Weighted-Average-Cost-of-Capital Using Re-
Levered Beta
The previous calculation, basic K-
wacc
, used the published Beta coefficient as a given.
The advanced approach explained here adds one element to the calculation: it adjusts
the Beta to match the target capital structure of the business for which you are
calculating k-
wacc
.
A company with a higher debt ratio will have a higher K-
wacc
, reflecting its higher risk. The
logic behind this process is straight-forward:
Weighted-average-cost-of-capital is used as a discount rate.
Discount rates adjust a series of cash flows for time value of money and risk.
Risk is divided into two categories; business risk and financial risk.
The higher the debt ratio, the greater the financial risk, the higher the beta.
More business risk means more variability in operating profit, which means a
higher beta.
Therefore, it makes sense to adjust the Beta coefficient to match it with the level
of financial risk incurred by the company.
An unlevered Beta, -ul, measures only business risk, based on a capital structure with
no debt in it, i.e., a debt ratio of zero. If a company has debt, it has financial risk in
addition to business risk. Since Beta must reflect both business risk and financial risk,
the unlevered Beta must be adjusted, making it a levered beta, -l.

Because published betas include both business risk and financial risk, the advanced
calculation of K-
wacc
has two steps:
The published Beta must be unlevered, to take out the impact of financial risk, as
if the company had a debt ratio of zero. This calculation uses the companys
existing debt ratio, in the equation -ul = -l (1 + D/E)
The resulting Beta must then be relevered using the companys target debt ratio,
in the equation -l = -ul x (1 + D/E)

This calculation is used for two purposes:
to estimate K-
wacc
for a company when the debt ratio is expected to change from
its present level
to estimate K-
wacc
for a company that does not have a published Beta because its
shares are not publicly traded. Betas for peer companies are used as proxies.
The debt ratios of the peer companies may not be the same as the debt ratio of
the company under analysis, so their Betas are first unlevered using their debt
ratios, and the resulting unlevered Betas are then relevered using the target
companys debt ratio.

The table below shows the advanced calculation:
1. Row 21 lists the existing debt ratio as debt to value.
2. Row 22 converts row 21 to debt to equity, as required by the equation.
3. Row 23 lists the published Beta
4. Row 24 unlevers the published Beta.
5. Row 26 lists the target debt to value ratio
6. Row 27 converts row 26 to debt to equity, as required by the equation
7. Row 28 relevers the Beta

The rest of the calculation is the same as for the basic calculation of K-
wacc
, except the

78
relevered Beta is used on row 39 instead of the published Beta.



Summary

Cost of debt, k
d
, is (somewhat) tangible
o Cost of Debt = Interest Rate x (1 - Tax Rate)
Cost of equity, k
e
, is a ghost lurking in a cloud
o Cost of Equity = Owners RRR = Risk-Free Rate + [Beta x Equity Risk
Premium]
Weighted average cost of capital, k
wacc

o k
wacc
= [Cost of Debt x % of Debt] + [Cost of Equity x % of Equity]
Beta, the slope of the OLS characteristic line, measures the relative volatility of
the stock compared to the volatility of the market.
20
21
22
23
24
25
26
27
28
29
30
31
32
33
34
35
36
37
38
39
40
41
42
43
A B C D
ADVANCED:
Market Value Leverage Ratio (D/V) 10.00% given
Market Value Leverage Ratio (D/E) 11.11% b21/(1-b21)
LEVERAGED (EQUITY BETA) 1.10 given
UNLEVERAGED (ASSET BETA) 0.99 b23/(1+b22) -ul = -l (1 + D/E)

TARGET Debt/Value Ratio 40% given
TARGET Debt/Equity Ratio 67% b26/(1-b26)
RE-LEVERED EQUITY BETA 1.65 b24*(1+b27) -l = -ul x (1 + D/E)
COST OF DEBT:
Coupon Rate 12.00% given
Marginal Tax Rate 18% given
Cost of Debt 9.84% b31*(1-b33) k-d = I x (1- t)
weight of debt 40% b26 d d+e
COST OF EQUITY:
Risk-Free Rate 10.00% given
Risk Premium 8.00% given
Beta 1.65 b28
Cost of Equity 23.20% b37+(B38*b39) k-e = R-f + [ x (R-m - R-f)]
weight of equity 60% 1-b34 e d+e
Weighted-Average Cost of Capital 17.86% (b3*b34)+(b40*b41) (k-d x wt-d)+(k-e x wt-e)

79

Step 3: Calculate Decision Criteria: Net Present Value, Profitability Index,
Internal Rate of Return, Payback Period

Financial analysts use four
6
decision criteria to measure the relative desirability of proposed
investment projects.
1. Net Present Value (NPV), which applies time value of money
2. Profitability Index (PI), also called Benefit-Cost Ratio (BCR), transforms the
dollar measure of NPV to a ratio measure to facilitate ranking several projects
from best to worst.
3. Internal Rate of Return (IRR), which applies time value of money
4. Payback Period (PP), is considered conceptually inaccurate because it does
not consider time value of money, even though it is popular among managers.

Each of the four decision criteria is calculated in Section V of the Generic Capital Budgeting
Template, rows 49-52. Cell B48 displays the discount rate of 10%, a given. B49.B52 are
calculated.


Net Present Value (NPV)

Net present value measures, in absolute (not relative) money terms, the difference between
the present value of cash inflows and the investment outlay. k
wacc
is used as the discount
rate. Algebraically,


where FCF
1
, FCF
2
through FCF
n
are the periodic free cash flows, FCF
0
is the investment
outlay at period zero, and k the discount rate k
wacc
.

The minimum acceptance criterion would be NPV=0, because a zero NPV means that the
project rate of return equals the discount rate, the discount rate (weighted average cost of
capital) used in the analysis, the minimum acceptable rate of return.

Important Warning When Calculating NPV in Excel. Excels =NPV financial function
is a misnomer. If you use it carelessly, you will get the wrong NPV that could lead to the
wrong decision. =NPV calculates the present value of the cash flows in the cell range cited.

6
A fifth metric is sometimes seen, even though it violates Time Value of Money rules and is
considered archaic. It is Return on Capital Employed (ROCE), using average profit in the
numerator and assets employed in the denominator, i.e., a return on assets ratio.

0
3
3
2
2
1
1
) 1 ( ) 1 ( ) 1 (
FCF
k
FCF
k
FCF
k
FCF
NPV !
+
+
+
+
+
=
47
48
49
50
51
52
A B C D E F G
Discount rate (K-wacc) 10%
Net Present Value (NPV) 2,658
Profitability Index (PI) 2.3
Internal Rate of Return (IRR) 54%
Payback Period inspection =if(c45<1,0,(c4+(D57+(=range(c45.d45))
SECTION V. CALCULATE DECISION CRITERIA USING FREE CASH FLOW

80
The number in the first cell is treated as one period hence, and so on. Therefore, enter the
function this way:

=NPV(discount rate, cell range periods one thorough n)

then, enter the initial cash flow for the capital expenditure at period zero, so cell B49 looks
like this:

=NPV(discount rate, cell range periods one thorough n) + (outlay at time period zero)

Be mindful of the sign on the cash flow in B44. It is a cash outlay and must be treated as a
negative number.

Years ago one user of electronic spreadsheets entered the entire cell range, period zero
through n, instead of the approach explained above. His NPV results were wrong, bad
decisions were made, he lost his job, he sued the software company, and the judge threw
the case out of court finding that the user of the software holds the responsibility for
knowing how it works, not the software company.

Profitability Index (PI), also called Benefit Cost Ratio (BCR)

A variation on NPV is the Profitability Index, transforming the NPV to relative (not absolute)
terms, stated as a ratio:

PV of Free Cash Inflows
PV of Investment Outlay

A Profitability Index of 1.0 times is the minimum acceptance criterion, where the numerator
and denominator are the same number. If NPV = 0, then PI = 1.0. A PI above 1.0 is
favorable; a PI below 1.0 is unfavorable.

Internal Rate of Return (IRR)

Internal rate of return is stated as a percentage rate of return (NPV is stated in money
terms and PI is stated as a ratio). The IRR is the discount rate that makes the present value
of cash inflows equal to the investment outlay, giving a Net Present Value of zero. Where
NPV is calculated with a formula, IRR is an identity and cannot be calculated. It is the result
of a trial-and-error calculation. In Excel, the computer starts with a guessed-at discount
rate, discounts the cash flows in periods 1 through n to get their present value, then
compares that present value to the period zero investment outlay.

Visualize the IRR process with the formula below for NPV, the same one discussed above.
Instead of entering the FCFs and k to calculate NPV, Excel enters a different k, one at a
time, until it gets NPV=0. The k where NPV=0 is the IRR.




0
3
3
2
2
1
1
) 1 ( ) 1 ( ) 1 (
FCF
k
FCF
k
FCF
k
FCF
NPV !
+
+
+
+
+
=

81
The Excel panel below illustrates an Excel calculation of IRR. Inputs go in row 35. I35 is a
$100 deposit in a bank account at year 0 (I34). It MUST have a negative sign on it or the
calculation will not work. The negative sign indicates that it is a cash outflow. The inflows
are in J35.N35, representing $10 in interest received at the end of years 1-4, and the final
$110 cash flow at the end of year 5 when the account is closed (final interest payment plus
original deposit made at year zero). Excels built in function for calculating IRR is entered in
I33: =IRR(I35.N35). Excel goes to work and produces the result in I33, IRR =10%. J33 is a
label.

The illustration above provides another useful way to think of IRR. Its analogous to the rate
of return on a bank account where you can deposit $100, then withdraw $10 a year for 5
years, then get your original $100 back.

WARNING: Florida Tile Buyout, which IRR is correct, 2900% or 211% ?

A journalist got himself in trouble by reporting the rate of return on the
leveraged buyout of Florida Tile as 2900% (B3). He forgot to enter zeros in
cells C3 & D3, so Excel did not know how to execute the calculation. Zeros in
cells C7 and D7 give the correct rate of return, 211%, B8. Theres a big
difference between 2900% and 211% annual rate of return. Be careful when
you use Excel to compute IRR. Missing zeros in C2 and D2 cause Excel to
consider those periods as non-existent, so it calculated on a 1-year basis
instead of 3-years.



Payback Period (PP)

The payback period measures, in years, how long it takes to get your money back after
making an investment. By cumulating the free cash flows year-by-years, as shown below,
you can easily see, by inspection, how many years it takes to recover the investment of
$2,000 at year zero. The cumulative free cash flows shift from negative to positive during
year two, from -835 in C45 to 414 on D45. Therefore, the PP is about 2 years.

Rather than saying, inexactly, that payback takes about two years, perform a linear
interpolation to find out exactly when during year 2 the cumulative free cash flow goes from
minus to plus (assuming that the cash flows occur smoothly throughout the year, which is
unlikely). From -835 to 415 is a change of 1,249. From -835 to 0 is a change of 835. So,
835 divided by 1,249 gives you the zero-point during year 2, 67%. Then you can say that
the PP is about 1.7 years.
1
2
3
4
5
6
7
8
A B C D E
2003 2004 2005 2006
-750,000 22,500,000
IRR 2900%
2003 2004 2005 2006
-750,000 0 0 22,500,000
IRR 211%
33
34
35
I J K L M N
10% IRR
0 1 2 3 4 5
-100 10 10 10 10 110

82


Variations on the Discount Rate calculated by the Cost of Capital Template

You can use the weighted average cost of capital, K-
wacc
, as calculated with the Cost of
Capital Template, in cell B48 of the Generic Capital Budgeting Template. However, other
choices can be made. Two are discussed here:

First is the issue of a corporation-wide discount rate versus tailored discount rates
used for divisions of a corporation that have different lines of business, as in a
conglomerate corporation. To the extent that analysts can agree about this, tailored
divisional discount rates are thought to be superior to a single corporate rate. The discount
rate should embrace the risk dimensions for the specific type of business that is under
analysis, recognizing that these metrics vary widely between industries. A standard practice
is to conjure up tailored discount rates for each division of a multi-industry corporation,
using peer companies within each industry.

Second is the issue of different discount rates for different categories of projects within the
same corporation, even within a single line of business. This means the use of risk-
adjusted discount rates. When dozens or hundreds of project proposals are under
review, not all of the projects have the same risk levels, meaning that the forecasted cash
flows for some are much more certain than others, depending on the nature of the project.
Typically, an array of discount rates is used, suggested by the table below.








The first category, safety or environmental projects, have a low discount rate barrier,
causing NPV to be higher and giving the project an easier shot at getting a green light.
Some of these projects might be considered necessary, without regard to NPV being
above or below zero, such as environmental or safety projects.

The second category, engineering efficiency projects, have cash flows which are
reasonably certain based on engineering estimates and prior experience with the
technology. Therefore, with little expected variation from the forecasted cash flows, they
can be viewed as low risk and therefore can be assigned a relatively low discount rate.
Examples of such projects are improved electric motors and labor saving processes.

The third and fourth categories involve either projects that the company is already
familiar with because they extend existing products or services, or new ones that the
company is not already familiar with. The more familiar the company is with making and
selling the product or service, the more predictable are the cash flows, and the lower the
risk. To be sure, any product or service proposal is likely to have more risk than an
engineering project, and the discount rate becomes risk adjusted accordingly.
44
45
A B C D E F G
Free cash flow -2,000 1,165 1,249 1,249 1,249 1,249
Cumulative free cash flow -2,000 -835 414 1,663 2,912 4,161

83

The spreadsheet below illustrates variations in cost of capital by industry, for several
industries at the top of alphabetical order. The entire data base can be found at:
http://pages.stern.nyu.edu/~adamodar/ by scrolling to Costs of Capital by Industry
Sector. Recall the discussion above about beta; the data base shows you that it also
varies by industry.

Discounting cash flows to their present value, using a risk-adjusted discount rate, can
introduce unintended bias into the analysis. Future cash flows are discounted more
heavily, implying that they are more risky. In fact, as a project matures, its cash flows
may be less risky if it survives its startup years.

Critique of NPV and IRR

The NPV method requires the financial analyst to input a discount rate, which may be
difficult to determine accurately. The NPV is stated in absolute money terms, which may be
difficult to interpret. Because of these two characteristics of NPV, many managers prefer
IRR as a decision criterion because it does not require a discount rate as an input and it is
stated as an easy-to-understand percentage. But the IRR method has a problem. The
compounding process inherent in the IRR calculation assumes that cash inflows can be
reinvested in the business at the same rate as the IRR. When IRRs are high, this
reinvestment rate assumption is often violated, rendering the IRR less accurate than NPV
as a decision criterion. Therefore, theorists consider NPV to be the superior decision
criterion for the capital budgeting process. Transforming it into PI turns the hard-to-interpret
absolute dollar amount into an easier-to-understand relative number a ratio.


A Worked Out Example: Red or Green Light for a Proposed New Product?

Now that you understand what the capital budgeting process is about, consider this
example. Universal wants to build a new plant and begin producing and selling a new
product that did well in focus groups and test markets (whose costs are sunk costs and
not relevant costs in the capital budgeting analysis). It uses the Generic Capital
Budgeting Template to see whether or not the decision criteria lead to an accept or
reject decision for the new product.

See the filled-in template below:

These are the inputs always remember that they are forecasts:
35% tax rate entered in B15
days of receivables, inventory, and payables of 45,30, and 30, respectively,
entered in B30.B32
$300,000 for plant and equipment (all data are entered in the template omitting
(000) entered in B42 the other cells in row 42 are left blank because no further
capital expenditure is expected beyond the initial year
10.9% for cost of capital entered in B48, taken from Cost of Capital Template on
page 74
row 5 gets year by year estimates of number of units of product sold
row 6 gets year by year estimates of the selling price of one unit of product
rows 8 & 9 get variable cost estimates

84
rows 10 & 11 get fixed cost estimates (when no fixed vs. variable cost estimates
are available, use judgment)
row 12 gets depreciation expense, based on 300 for plant and equipment in B42
and 10-year useful life
Those are the only entries required. The formulas in the Excel spreadsheet do
their work and generate the decision criteria in Section V. NPV, PI, IRR all
indicate an accept decision, a green light for the proposed project. (The payback
period is about 3.5 years.)







85

Summary

The course logo below repeats the emphasis on cash: Cash is King! Throughout this
chapter, you identified the relevant cash flows, not accounting accruals (remember the
cigar box analogy). At this point, you should be able to easily define free cash flow as
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
32
33
34
35
36
37
38
39
40
41
42
43
44
45
46
47
48
49
50
51
52
A B C D E F G
Year 0 1 2 3 4 5
Units sold 20.0 25.0 30.0 35.0 40.0
Sales price per unit 5.0 5.0 5.0 4.5 4.5
Sales revenue 100.0 125.0 150.0 157.5 180.0
Less: variable cost of good sold 1.0 1.0 1.0 1.0 1.0
Less: fixed cost of goods sold 2.0 2.0 2.0 2.0 2.0
Less: variable GS&A expense 0.5 0.5 0.5 1.0 1.0
Less: fixed GS&A expense 1.0 1.0 1.0 1.0 1.0
Less: depreciation 30.0 30.0 30.0 30.0 30.0
Equals: total operating expense 34.5 34.5 34.5 35.0 35.0
Equals: EBIT 65.5 90.5 115.5 122.5 145.0
Income tax rate & income tax 35% 22.9 31.7 40.4 42.9 50.8
Operating cash flow:
EBIT 65.5 90.5 115.5 122.5 145.0
Minus: Taxes 22.9 31.7 40.4 42.9 50.8
Plus: Depreciation 30.0 30.0 30.0 30.0 30.0
Equals: Operating cash flows 72.6 88.8 105.1 109.6 124.3
Change in Net Working Capital:
Revenue 100.0 125.0 150.0 157.5 180.0
Cost of goods sold 3.0 3.8 4.5 4.7 5.4
Receivables (enter days in Column B) 45 12.3 15.4 18.5 19.4 22.2
Inventory (enter days in Column B) 30 0.2 0.3 0.4 0.4 0.4
Payables (enter days in Column B) 30 0.2 0.3 0.4 0.4 0.4
Net working capital needs 12.3 15.4 18.5 19.4 22.2
Liquidation of working capital 1.0
Investment in working capital 12.3 3.1 3.1 0.9 1.8
Free cash flow:
Operating cash flow 72.6 88.8 105.1 109.6 124.3
Minus: Invesment in net working capital 12.3 3.1 3.1 0.9 1.8
Minus: Investment in PPE (CapEx) 300.0 0.0 0.0 0.0 0.0 0.0
Plus: Salvage value 0.0
Free cash flow -300.0 60.2 85.7 102.0 108.7 122.5
Cumulative free cash flow -300.0 -239.8 -154.0 -52.0 56.7 179.2
Discount rate (K-wacc) 10.9%
Net Present Value (NPV) 43.7
Profitability Index (PI) 1.1
Internal Rate of Return (IRR) 16%
Payback Period inspection of cumulative FCF - row 45
SECTIONS II AND III, IN ADDITION TO THE CHANGE IN CAPITAL SPENDING
SECTION V. CALCULATE DECISION CRITERIA USING FREE CASH FLOW
SECTION I. CALCULATE THE CHANGE IN EBIT, TAXES, AND DEPRECIATION (THIS BECOMES
AN INPUT IN THE CALCULATION OF OPERATING CASH FLOWS IN SECTION II)
enter data in blue-colored cells
SECTION II. CALCULATE OPERATING CASH FLOW (THIS BECOMES AN INPUT IN THE
CALCULATION OF FREE CASH FLOW IN SECTION IV)
SECTION III. CALCULATE THE NET WORKING CAPITAL (THIS BECOMES AN INPUT IN THE
CALCULATION OF FREE CASH FLOWS IN SECTION IV)
SECTION IV. CALCULATE FREE CASH FLOW (USING INFORMATION CALCULATED IN

86

EBIT AFTER TAX PLUS DEPRECIATION EXPENSE MINUS INCREASE IN NET
WORKING CAPITAL MINUS CAPITAL EXPENDITURE,



Free cash flow is calculated on row 44 of the Generic Capital Budgeting Template.
Commit the definition to memory. Look at the IS/BS Model at the beginning of this
chapter to refresh your memory about where each of these numbers comes from.
Strengths and weaknesses of capital budgeting decision criteria are listed below:
+ means strength
- means weakness
NPV
+ shows value created by project
+ theoretically accurate uses time value of money
- cant use corporate k
wacc
but divisional hurdle rates
- absolute dollar value, not a relative, hard to rank
- mathematics of discounting introduces distortion
- scale
- duration
Profitability Index (or Benefit-Cost Ratio)
+ puts NPV in relative terms
IRR
- reinvestment rate assumption
+ intuitive appeal to managers
+ stated as percentage
Payback Period
- liquidity of project
- no time value of money
- ignores cash flows after payback
+ can discount cash flows before calculating payback period
+ cumulative cash flows easily understood

Also, know that a business can deploy money in only four ways:
1. Invest in working capital and PPE to expand via organic growth
2. Invest in other companies, growing via merger and acquisition
3. Payment of a dividend to its shareholders
4. Repurchasing its own stock



87

CHAPTER 6
EQUITY VALUATION

How much is a company worth? The methods in this chapter shed light on this
perplexing question deciding how much to pay for a share of a company, the whole
company if you are buying, or how much to ask for if you are selling. If there is a market
price from a stock exchange, over-the-counter trading, or a recent transaction of a
privately held company, you have a starting point for an analysis. This chapter explains
two models, the free cash flow model and the market multiples model. They purport
to measure fair value, also called intrinsic value, which may or may not be the same as
market price. Notice the distinction in terminology: market price and fair value. We know
the price because it comes from an actual transaction in a market place. We know value
based on the calculations in a model.

Learning Objectives:
1. Understand the foibles of equity valuation.
2. Appreciate that the capital budgeting analysis in Chapter 5 uses free cash
flow to value one project alone. To refresh your memory, use the flow
diagram below to check the green boxes depicting capital budgeting analysis.
The analysis in this chapter values the whole business - all the projects, not
just one alone using similar methodology based on free cash flow.
3. Realize that market price is not the same as fair value.
4. Learn how to use, and not abuse, the free cash flow and market multiples
equity valuation models.

The blue boxes in the Flow Diagram depict the two valuation models discussed in this
chapter, Free Cash Flow and Market Multiples. Notice that the Free Cash Flow Model
depends on k
wacc
for its discount rate. After the equity value is calculated using one or
both of these models, that value is used as an input in the financing decision, in the red
boxes. Financing is covered in Chapter 7.


88


Similarly, check the IS/BS Model on the next page to make sure you are keeping track of
how the analytic tools fit together. Here we are dealing with the blue block in the IS/BS
Model. Notice that the valuation equation portrayed there, cash flow divided by cost of
capital, is a simple equation that capitalizes cash flow to estimate value. The valuation
models presented in this chapter provide a more complex, more realistic valuation
methodology based on cash flows over time rather than a single-period cash flow.

Market Price vs. Value

Recall the distinction between price and value; they are not equivalent. Market price is the
amount of money paid when shares are exchanged. A companys share, priced today at
$15.25, may be priced next month at $12.00 or $19.50, or lower, or higher. Two months
ago it may have been priced at $8.00 or $22.25. Fair value is the intrinsic worth of a
company, based on its ability to generate cash flow for its owners, apart from the temporary
market forces that determine its market price on any particular day. For this reason, you
should not expect the results of a valuation analysis to be equivalent to the market price on
any given day.

The analysis here assumes a going concern; meaning that cash flow generated by an
operating business, a going concern, determines its value. Before the discussion of going
concern value gets started, it is useful to define three other measures of value:

Book value is another term for equity, the figure on the balance sheet. Book value per
share is equity divided by the number of shares issued. Because the dollar amount of
equity is based on the amount of money received when shares were newly issued, plus
profit reinvested in the business (retained earnings), there may be no logical relationship
between book value, price, and value.

ANALYSIS STEPS: FINANCING DEBT EQUITY
1-HISTORICAL RATIOS DEBT
2-K-WACC HISTORICAL RATIOSI/S & B/S FORECAST EFN
3-CAPITAL BUDGETING
4-FORECAST & EFN
I/S, B/S, & RATIOS EQUITY
5-EQUITY VALUATION EBIT CHART
6-FINANCING
income risk control mktblty flexblty timing

OP & CAP NATCF, NPV, IRR, PAYBACK
K-WACC
ENTERPRISE VALUE USING FREE CASH FLOW
MARKET MULTIPLES: P/E, MV/BV, REV, EBIT

89

Liquidation value is the amount of money that could be raised if all assets were sold, less
total liabilities.

Replacement value is the amount money it would require to replace, at current market
prices, the assets of a business, less total liabilities.

Valuing shares of a company is a combination of art and science. You use a model that has
the appearance of a precise scientific approach, but deciding which numbers go into the
model requires artistic forecasting based on judgment and experience. It is useful to
determine a range of possible values, rather than looking for an exact value. Then, a
negotiation process between the parties involved in a deal narrows the range until
agreement about a price is reached. If no negotiation process is involved, you can simulate
one by posing the differing viewpoints of potential buyers and sellers. Sellers assume a
best-case scenario; buyers do the reverse. Human nature dictates that sellers want to sell
at the highest possible price; buyers want to buy at the lowest possible price.

Develop a questioning mode of thinking about the valuation process and learn to
combine all of the involvedto approach this valuation process with a combination of
artistic and scientific judgment.


The Purposes of Estimating Fair or Intrinsic Value
Determine if the market undervalues or overvalues your shares
Value a sale or purchase of all or part of a business either for cash or for shares
or a combination of cash and shares
Set an offering price for shares in an initial public offering (selling newly-issued
shares) or secondary offering (selling already-issued shares)
Set the terms of exchange and/or cash investment in privatization, joint-venture, or
buyout deals




90
Chapter 6 opens with comments about the validity of the valuation process, so you can
think about its foibles from the outset. Too many finance professors and textbooks
take valuation too literally by accepting the modeling results without question. Modeling
appears to be scientific, but it is not. There is a lot of art behind it. Please keep this
notion in mind as you go through the material here.



The slight of handlegerdemain poster invites you to think of valuation as something
manipulated by a showman. Is that going too far? Is equity valuation beauty in the eye of
the analyst beholder? Yes! How can you escape that conclusion when you realize that
skilled, knowledgeable analysts have different opinions about value.

Read on, about Skype and Google. The Skype deal is one of the classics, $2.6 billion
paid in 2005 for a company with no profits. Google mounted a notorious Initial offering,
also in 2005.

Below are two press clippings about Skype. The first one reports the eBay purchase of
Skype in 2005, highlighting consternation about the $2.6 billion valuation, taking note of:
Transaction price being compared to value.
Use of financial ratios.
Use of comparables from businesses judged to be peers.
Use of forecasted revenue and expense
The second one reports the prediction that Skype could be worth twice its 2010 valuation
of $2.75 billion. As you read, wonder about where these valuations come from: thin air -
market hype, rigorous analysis.

1-eEBay Draws Skype Skeptics (excerpts):
By Mylene Mangalindan, The Wall Street Journal, October 3, 2005
Wall Street is wondering just how eBay Inc. will get its $2.6 billion acquisition
of Skype Technologies SA to pay off.
Citigroup Inc. analyst Mark Mahaney says he can justify only half of the deal's
$2.6 billion price tag. Mr. Mahaney, who rates the stock "buy" and doesn't own
eBay shares, calculates that if Skype produces 2006 revenue of $200 million and
generates a 25% earnings margin before interest, taxes, depreciation and
amortization, Skype's earnings will total $50 million. If $50 million is multiplied
by a 25-times multiple -- the number that was used to value other Internet deals
such as eBay's purchase of Shopping.com and IAC/InterActive Corp.'s
acquisition of Ask Jeeves -- that results in a $1.3 billion value.

91
Mr. Mahaney acknowledges, however, that there may be "material synergies"
between eBay and Skype, considering Skype has 54 million global users to add
to eBay's 157 million registered users and 79 million PayPal accounts. But, he
adds, the deal's valuation requires "aggressive assumptions."
Rajiv Dutta, eBay's chief financial officer, says Skype is a great stand-alone
business, one that benefits as more people join the network. He says the proper
context for valuing Skype is by comparing it to eBay and PayPal at the same
stage in their development. After two years of generating revenue, Skype's
projected revenue of $60 million this year beats the $47 million eBay generated
at the same point in its life, though it falls short of the $100 million that PayPal
was producing in its second year.
By some measures, eBay is paying less for Skype than it did for other deals, Mr.
Dutta says. By shelling out $2.6 billion for Skype's 54 million customers, the
Internet auctioneer is spending $55 for each Skype customer, less than the $80 it
paid for each PayPal customer, he notes. In addition, the Skype purchase is 4.8%
of the eBay's market value of $55 billion, while PayPal was 8%.
Mr. Dutta concedes that investors may have a hard time justifying the deal's
valuation because the business eBay is building with Skype "doesn't in fact exist"
yet. He says the company plans to gain revenue by layering other services that
consumers will have to pay for on top of Skype's technology.
At least one Wall Street analyst is on eBay's side. Anthony Noto, a Goldman
Sachs Group Inc. analyst, says Skype can help eBay generate revenue from the
1.9 billion monthly searches that take place on its sites by posting pay-per-call
sponsored listings, or paid advertising, on the top of search-results pages.
Mr. Noto, who rates the stock "outperform" and doesn't own eBay shares,
estimates eBay can produce $365 million to $900 million in incremental revenue
a year through such listings with the calls priced at $2 to $5. By applying a 60%
operating margin and a 40% tax rate, he calculates eBay's potential sponsored
listings revenue will yield incremental net income of $130 million to $325
million.
2-Skype on Deck
by Robert Cyran and Rob Cox, Considered View (online), March 15, 2010
the former eBay orphan could steal the scene with a quick flip. After
clarifying copyright issues and rewriting its code to attack the business market,
the internet telephony group may be worth twice the $2.75 billion it sold for last
year.
Now, read about Google. The first panel of data comes from its initial public offering on
August 19, 2004 at $85 per share, giving it a market capitalization of $23.1 billion the
market price on that day of all the common stock outstanding.


92
No matter how hard Googles managers and advisers tried to market their initial public
offering at the best possible price, it sold at $85 per share, a relatively low price
compared to what they had in mind. Was this a mistake? How much money did they
leave on the table, if they could have gone to market at $100 (the price of first secondary
market trade after the primary market IPO), or $125, or $150? According to a news
report on July 26, 2004, Google set the price range at $108 to $135 per share. But, by
the time August 19 rolled around, the IPO price was $85. How would you feel if you sold
your company at $85 and then saw it rise to $100 the same day, and then nearly $400 in
less than 18 months? Why cant equity valuation experts do a better job of forecasting
(estimating/predicting), so Googles initial investors couldnt buy so cheaply? They cant.
Its impossible. Its based in forecasting the unknown future. More than the future
performance of the company is involved. Other factors include: performance of the
economy, performance of the industry and peer companies, performance of the overall
market, and investor attitudes about risk taking.

From www.google-ipo.com

IPO Date: August 19, 2004
First Trade:11:56 am ET at $100.01
Price: $85.00
Method: Modified Dutch Auction
Lead Underwriters: Morgan Stanley, Credit Suisse First Boston
Stock Symbol: GOOG
Exchange: NASDAQ
No. of Shares Offered: 19,605,052
Value of Offering: $1.67 billion
Initial Market Cap: $23.1 billion
Total Initial Shares Outstanding: 271.2 million
(33.6 mil. class A, 237.6 mil. class B)

From http://finance.yahoo.com/q/bc?s=GOOG




93
As of November 2, 2005, Googles market price per share was $379.29 (P/E ratio of
about 84 times); its market capitalization was about $103 billion. For comparison, Wal-
Marts market capitalization the same day was about $210 billion (P/E of about 18
times), a little more than twice as much.

Now look at the chart below showing Google on September 2, 2011, with a per share
price of $524.85 (P/E ratio of about 19 times) and a market capitalization of about $170
billion. Wal-Marts market capitalization in the same day was about $179 billion, with a
P/E ratio of about 11 times.


94

Google as of September 2, 2011
http://finance.yahoo.com/q/bc?s=GOOG&t=my&l=on&z=l&q=l&c=


Last Trade: 524.84
Trade Time: Sep 2
Change:
7.66 (1.44%)
Prev Close: 532.50
Open: 525.00
Bid: 523.10 x 100
Ask: 527.00 x 100
1y Target Est: 720.43
Day's Range: 520.73 - 527.92
52wk Range: 463.02 - 642.96
Volume: 2,402,024
Avg Vol (3m): 3,794,040
Market Cap: 169.46B
P/E (ttm): 18.93
EPS (ttm): 27.72
Div & Yield: N/A (N/A)


95
The table below summarizes the changes in Googles and Wal-Marts market
capitalization and P/e ratios:

Name 2004 2005 2011
Google $23 billion $103 billion
84 x earnings
$170 billion
19 x earnings
Wal-Mart NA $210
18 x
$179
11 x

As its market capitalization grew from $103 to $170 billion, Googles P/E came back to
earth in 2011 to a reasonable level of 19 times from 84 times in 2005. Wal-Marts market
capitalization fell from $210 to $179 billion, as its P/E fell from 11 to 11 times earnings.
Will Googles future value justify its current price? Is Wal-Mart on the decline, even
though it is one of the largest companies in the world?



96

Similarity of Free Cash Flow in Capital Budgeting and Equity Valuation



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A B C D E F G
Year 0 1 2 3 4 5
Units sold 0.0 0.0 0.0 0.0 0.0
Sales price per unit 0.0 0.0 0.0 0.0 0.0
Sales revenue 0.0 0.0 0.0 0.0 0.0
Less: variable cost of good sold 0.0 0.0 0.0 0.0 0.0
Less: fixed cost of goods sold 0.0 0.0 0.0 0.0 0.0
Less: variable GS&A expense 0.0 0.0 0.0 0.0 0.0
Less: fixed GS&A expense 0.0 0.0 0.0 0.0 0.0
Less: depreciation 1.0 1.0 1.0 1.0 1.0
Equals: total operating expense 1.0 1.0 1.0 1.0 1.0
Equals: EBIT -1.0 -1.0 -1.0 -1.0 -1.0
Income tax rate & income tax 0% 0.0 0.0 0.0 0.0 0.0
Operating cash flow:
EBIT -1.0 -1.0 -1.0 -1.0 -1.0
Minus: Taxes 0.0 0.0 0.0 0.0 0.0
Plus: Depreciation 1.0 1.0 1.0 1.0 1.0
Equals: Operating cash flows 0.0 0.0 0.0 0.0 0.0
Change in Net Working Capital:
Revenue 0.0 0.0 0.0 0.0 0.0
Cost of goods sold 0.0 #DIV/0! #DIV/0! #DIV/0! #DIV/0!
Receivables (enter days in Column B) 0 0.0 0.0 0.0 0.0 0.0
Inventory (enter days in Column B) 0 0.0 #DIV/0! #DIV/0! #DIV/0! #DIV/0!
Payables (enter days in Column B) 30 0.0 #DIV/0! #DIV/0! #DIV/0! #DIV/0!
Net working capital needs 0.0 #DIV/0! #DIV/0! #DIV/0! #DIV/0!
Liquidation of working capital 1.0
Investment in working capital 0.0 #DIV/0! #DIV/0! #DIV/0! #DIV/0!
Free cash flow:
Operating cash flow 0.0 0.0 0.0 0.0 0.0
Minus: Invesment in net working capital 0.0 #DIV/0! #DIV/0! #DIV/0! #DIV/0!
Minus: Investment in PPE (CapEx) 0.0 0.0 0.0 0.0 0.0 0.0
Plus: Salvage value 0.0
Free cash flow 0.0 0.0 #DIV/0! #DIV/0! #DIV/0! #DIV/0!
Cumulative free cash flow 0.0 0.0 #DIV/0! #DIV/0! #DIV/0! #DIV/0!
Discount rate (K-wacc) 0%
Net Present Value (NPV) #DIV/0!
Profitability Index (PI) #DIV/0!
Internal Rate of Return (IRR) #VALUE!
Payback Period inspection of cumulative FCF - row 45
SECTIONS II AND III, IN ADDITION TO THE CHANGE IN CAPITAL SPENDING
SECTION V. CALCULATE DECISION CRITERIA USING FREE CASH FLOW
SECTION I. CALCULATE THE CHANGE IN EBIT, TAXES, AND DEPRECIATION (THIS BECOMES
AN INPUT IN THE CALCULATION OF OPERATING CASH FLOWS IN SECTION II)
enter data in blue-colored cells
SECTION II. CALCULATE OPERATING CASH FLOW (THIS BECOMES AN INPUT IN THE
CALCULATION OF FREE CASH FLOW IN SECTION IV)
SECTION III. CALCULATE THE NET WORKING CAPITAL (THIS BECOMES AN INPUT IN THE
CALCULATION OF FREE CASH FLOWS IN SECTION IV)
SECTION IV. CALCULATE FREE CASH FLOW (USING INFORMATION CALCULATED IN

97
To refresh your memory, take a quick look at the Generic Capital Budgeting Template from
Chapter 5, shown above. Recall how row 44, free cash flow, is calculated. You will find that
it is exactly as stated in the equation above, via the Excel formula. Find this template in
TemplateSet.xls, put your cursor on the cells in row 44, to see the formula that does the
work.

(EBITTax Rate) + Depreciation +/- Change in Net Working Capital +/- Capital
Spending = Free Cash Flow

In the sections below, you get a detailed look at the Free Cash Flow Model for equity
valuation, realizing that FCF is the same in both models, Capital Budgeting and Valuation.
Think if it this way: in capital budgeting, you value one project. In equity valuation, you value
the entire business the methodology for both is very similar.

Basic Metrics

Two versions of the following basic formula is a good starting point for the discussion of
value. Money is invested in a business for the purpose of generating cash flow going back
to the investor. Rate of return is determined by the ratio of profit to investment, stated as a
percentage. The proportion between the two is called rate of return. When you know how
much investment is made, and how much annual cash flow is generated, the rate of return
percentage can be calculated.

1- Cash Flow Investment = Rate Of Return

Now, turn the above formula upside down. Instead of knowing the amount of the
investment, we know only the annual cash flow a business is capable of generating and the
rate of return an investor wants to earn. Rearranging the terms in the formula, you get

2- Cash Flow Rate Of Return = Investment

Therefore, by dividing rate of return into cash flow, the result is the amount of money that
can be invested to generate that amount of cash flow at that rate of return. This is called
capitalizing a cash flow to determine the amount of the investment it justifies, given a rate of
return. The figure in the denominator is called a capitalization rate, which is another way of
describing the rate of return an investor requires before parting with his or her money.

This formula depicts the relationship between RATE OF RETURN AND RISK, a sacred
concept in finance. It shows how value results when investors in the market place forecast
cash flow and the possible variation in that cash flow. To investors, variation in cash flows
means risk. With cash flow in the numerator of the formula, and with a rate of return
percentage in the denominator acting as the proxy for the risk inherent in the cash flows
the result is a value for the business inversely related to its risk. There is no more
fundamental principle of finance than this one: RETURN VARIES INVERSELY WITH
RISK. You can solve for rate of return knowing the cash flow and the amount invested, or,
you can solve for how much to invest (value), knowing the cash flow and the desired rate of
return.


98
The weighted average cost of capital, k
wacc
, as calculated in Chapter 5, was used as the
discount rate in the capital budgeting procedure discussed in Chapter 5. It will also be used
as the discount rate for the valuation procedure in this chapter. As you have noticed, the
greater the riskiness of the business, as perceived by investors in the capital market, the
higher will be their required rate of return, i.e., the discount rate they apply. You already
know from Time Value of Money methodology that discounting cash flows at a higher rate
givers a lower present value. Therefore, the riskier a business, all else the same, the lower
its value, because its cash flows are capitalized at a higher required rate of return.

Dividend Discount Model (DDM)

The theoretical value of a share is the present value of the future dividends it earns.



Algebraically, where D
1
, D
2
through D
n
are dividends received by investors in perpetuity,
and k is cost of equity, the discount rate representing the equity investor's required rate of
return. The Dividend Discount Model (DDM) is an algebraic simplification of the above
equation, assuming that the annual dividend, D, grows at a constant percentage g, and that
the perpetual dividend flows are discounted at a constant percentage k:

V
0
= [D
0
x (1+g)] / (k g)

The current dividend per share is used as the starting point. The growth rate can be taken
from past experience or set according to the judgment of the analyst. The discount rate is
the cost of equity. Note that the model works only when the discount rate is greater than the
growth rate. Simple as it seems, the DDM is the foundation of thinking about equity
valuation, and many security analysts present DDM results along with results of the free
cash flow model discussed next.

Internal Rate of Return (IRR)

The Apple IPO price on December 12, 1980 was $22.00 a share, which is $2.75 in
todays shares on a split-adjusted basis. An investment in 1,000 shares for $22,000
would be worth about $2.9 million as of December 12, 2010, 30 years later. Using the
IRR method, the investment in period 0 was -$2.75. The terminal price in period 30 is
$320. The IRR is 17.8% per year over this 30-year period.

For Google, the August 19, 2004 IPO price was $85. The August 19, 2011 price was
about $500. Therefore, the IRR for Google is 34.4% per year over this 7-year period; the
Excel calculation is shown below. Performing these calculations correctly requires cash
flows at annual intervals; thats why the terminal date is on the same day as the IPO, 7
years later. You must also make sure that the initial price is adjusted for any stock splits
that took place between the initial date and the terminal date.




n
n
k
D
k
D
k
D
V
) 1 (
.....
) 1 ( ) 1 (
2
2
1
1
0
+
+ +
+
+
+
=

99



Free Cash Flow Equity Valuation (FCF) Model

Financial analysts use the free cash flow model for estimating the fair or intrinsic value of a
business. It is based on data from forecasted income statements and balance sheets,
boiled down to free cash flow over a period of future years. The present value of these
future free cash flow flows equals the value of the business. The discount rate used to
calculate the present value of the free cash flows is the rate of return expected by investors,
calculated as K-wacc.

Following is a step-by-step explanation of the valuation for Universal Industries, using the
FCF Valuation Template shown below.


The term free is used to describe cash flow because it represents the cash flow remaining
after investing in the assets, both NWC and PPE, needed to support the growth in revenue.
These free cash flows are available to pay interest and repay principal to suppliers of debt,
and are available to pay dividends to suppliers of equity, or to reinvest in the business.
7


7
For a growing company, it is not unusual to get negative FCF figures, because in most companies, CFFO
growth is lower than the asset growth rate - especially when revenue is growing rapidly. This is the same thing
as the result of the forecast in Chapter 3, external financing needed, the plug figure, because assets must equal
liabilities plus equity. If a growing company has a positive free cash flow only in the last year of the forecast
period, its terminal value will be positive. Since terminal value is a large component of enterprise value, share
value will come out a positive number. When growth in revenue is eliminated from the forecast, the change in net
working capital and capital expenditure rows become zero, and FCF increases, because CFFO is a positive
number and there is no need to invest in more working capital and fixed assetsthe proverbial cash cow. You
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A B C D E F G
FREE-CASH-FLOW VALUATION OF EQUITY
Assumptions:
PERIOD 2011 2012 2013 2014 2015 2016
YEAR 0 1 2 3 4 5
Profit from operations (EBIT) 93.6 109.0 192.9 243.6 278.7
Income tax rate 15.6% 15.6% 15.6% 15.6% 15.6%
Depreciation & amortization expense 65.4 65.4 65.4 76.7 76.7
Net working capital from balance sheet forecast 164.9 184.4 214.8 235.1 290.2 324.6
Capital expenditures 150.0 0.0 0.0 150.0 0.0
Long-term growth rate 5.0%
Wt-Avg. C of C (K-wacc) 10.9%
Market Value of Debt 413.1
Number of Shares 150.0
Redundant Assets 0.0
PERIOD 2011 2012 2013 2014 2015 2016
YEAR 0 1 2 3 4 5
EBIT after tax (EBIAT) 79.0 92.0 162.8 205.6 235.2
+ Depreciation 65.4 65.4 65.4 76.7 76.7
=Cash Flow from Operations (CFFO) 144.4 157.4 228.2 282.3 311.9
+/- Change in Net Working Capital (19.5) (30.4) (20.3) (55.1) (34.4)
+/- Capital Expenditures (150.0) 0.0 0.0 (150.0) 0.0
=Free Cash Flow (FCF) (25.1) 127.0 207.9 77.2 277.5
+Terminal Value (TV) 4939.0
=Sum of FCF + TV (25.1) 127.0 207.9 77.2 5216.5
Present Value 3393.8
- Market Value of Debt 413.1
= Valuation of Equity 2980.7
+Redundant assets 0.0
=Adjusted Value of Equity 2980.7
/ Number of Shares 150.0
Value of Equity per Share ! 19.87

100

Income statement entries. The starting point is the LONG FORM FORECAST MODEL
(LFFM) from Chapter, or any other forecast you might have, entering data as follows:
1. Forecasted profit from operations (EBIT) from cells M18.Q18 in LFFM is
entered in the assumptions panel of the FCF VALUATION template in C5.G5.
Notice that money amounts are entered with zeroes omitted; be consistent in all
entries throughout the template to avoid errors.
2. Income tax rate from H23.L23 goes to row C6.G6
3. Depreciation/amortization expense from M14.Q14 goes to row C7.G7
These three entries are a simple matter of transferring data from the forecast template or
another source to the valuation template, rows 5-7.

Balance sheet entries. Next, from the forecasted balance sheet template, enter:
4. Net Working Capital (NWC) does not have its own line item in LFFM, so you
must calculate it separately as the sum of receivables + inventory payables,
the enter the NWC figures in B8.G8. The B8 number is not from the forecast; it
is NWC for the most recent historical period, 2011. It must be entered in the
base year column, column B, so incremental NWC can be calculated. A good
way to calculate NWC is to find a row of empty cells in LFFM and perform the
NWC calculation.
5. Capital expenditures is entered from H54.L54 in LFFM to C9.G9 in the valuation
template; it is based on engineers estimates of new plant, property and
equipment needed to achieve the revenue levels implied in the forecast, not
PPE as a percentage of sales which is a crude and likely incorrect estimate of
capital expenditure. Production can increase without investing in new PPE if
excess capacity exists in the existing PPE as is the case in many businesses.
If new PPE is required, the investment is based on how much it will cost, not a
percentage of historical PPE. For an external analyst lacking internal data,
capital expenditures is hard to forecast do the best you can.

Other data:
6. Enter a long-term growth rate in G10. The purpose of this growth rate is to
calculate a terminal value for free cash flows that will occur beyond the forecast
period, here 2016 in Column G. Standard valuation methodology uses a
growing perpetuity formula to calculate the terminal value based on the free
cash flow in G23 growing into perpetuity at the constant rate entered in G10.
Therefore, the growth rate must be a sustainable rate for the very long-term
future. Large annual growth rates are not sustainable. A typical growth rate is
2%-5%, depending on economic and industry characteristics, and the strategy
of the business. The growth rate must be smaller than the discount rate, or the
formulas in the valuation template will not work. If the business anticipates high
growth rates, extend the year-by-year forecast for those years, in their own
separate columns, until the growth rate normalizes. For the valuation of
Universal, the growth rate in G10 was set a 5%.
7. Enter K-wacc in B10, either from the Cost of Capital template or an estimate
from another source.

can see that a cash cow is a mature company with slow or no revenue growthit throws off cash because there
is no need to invest is new assets.


101
8. Enter market value of long-term debt in B12, but you probably do not have
market value data, so enter its book value from the most recent historical period
in the balance sheet. Combine all rows listing long-term debt into a single entry.
9. Enter the number of common shares outstanding in B13. The correct figure to
use is the number of shares outstanding at the end of the most recent historical
period. Remember: authorized shares do not count; only issued shares count.
Treasury shares are not issued shares; they do not count. Whether or not to
use fully diluted or primary shares is a judgment call that you can make.
Whichever one you choose, be consistent using the same number throughout
your analysis. Be careful about omitted zeroes; make sure all entries throughout
the template are consistent regarding omitted zeroes errors often result from
inconsistencies.
10. Enter redundant assets, if any, in B14. This includes excess cash or any other
asset on the books that is not needed to generate the revenue levels implied in
the forecast, i.e., they could be sold off without any change elsewhere in the
forecast.
11. The analysis is performed on rows 16-33, drawing data from the assumptions
data you entered in rows 1-14. Free cash flow (FCF) is defined as the sum of
cash flow from operations minus income tax minus change in net working
capital minus capital expenditures. Note that the all data from the forecasted
balance sheet template is not entered as it is it is transformed into the
incremental investment in net working capital and plant, property, and
equipment. It captures the year-to-year change, the new investment in the
business required support the growth plan. As revenue changes, net working
capital also changes spontaneously, which means that money must be
invested in the business to support the revenue increase. Recall the discussion
in Chapter 5 on Capital Budgeting, discussing the distinction between the year-
end totals for NWC and PPE on the balance sheet, and the year-by-year
incremental changes. You are measuring cash flows in this forecast; therefore
the year-by-year incremental changes are the correct figures to enter.
12. This forecast uses a 5-year time horizon; no results are shown beyond 2016.
Unless the business ceases to operate on that date and the liquation value of its
net assets on that date is zero, something must be added to the cash flow
analysis to represent what will happen in 2017 and beyond, namely, a terminal
value. Terminal value is the present value of all cash flows from the year 2017
into perpetuity, i.e., a proxy for all the free cash flows that are expected to occur
after 2016. A growing perpetuity formula is similar to the DDM, discussed
above.

TERMINAL VALUE = [FCF
n
x (1+g)] / (k-g)

where g in cell G10 is a sustainable long-term growth rate of 5% and K
wacc
in
cell B11 is cost of capital of 10.9%. Note that terminal value occurs at the end
of 2016 because it represents the present value of the growing perpetuity from
that period forward, shown in cell G24. Both the five FCFs and the one Terminal
Value (TV) are discounted to present value at 10.9%. The sum of the present
values, cell B27, is the enterprise value of Universal Industries. Enterprise value
is the value of the business to all suppliers of permanent capital, debt investors
and equity investors.
13. To determine the value of equity, the value of long-term debt in cell B28 is
deducted from enterprise value. Therefore, the intrinsic value of equity, cell B29,

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is viewed as a residual value of enterprise value, net of debt. Adjust it by adding
redundant assets, if any. Then divide B31 by shares outstanding in cell B32 to
get per share intrinsic value, cell B33. The resulting value of 19.87 EUR can
then compared to the current market price, whatever it is, to determine if the
company is overvalued or undervalued (and the percentage of over-valuedness
or under-valuedness).

Complications

It is possible for Cash Flow From Operations (CFFO) to be negative, especially in early
years of growth before projects reach profitability. If the business invests in net working
capital and fixed assets during the same years when CFFO is negative, free cash flow will
be negative. This should not be surprising because it is the normal condition of a growing
business, absorbing more cash flow than it generates, requiring external financing, as seen
in the forecast.

Change in net working capital can be a negative number (a cash inflow), indicating that
revenue is declining and working capital needs are falling. Similarly, capital expenditure can
be negative if fixed assets are divested. Keep careful track of the signs on these cash flows
increases signify uses of funds decreases signify sources of funds.

More on Terminal Value

Point 12 above defined and explained the growing perpetuity formula as a proxy for
terminal value in the Free Cash Flow Valuation Model. It is standard methodology. There
are, however, other proxies to use instead of the growing perpetuity model. Which one to
use, the standard method as explained above, or an alternative, is a matter of judgment by
the analyst about which terminal value proxy best represents reality. Dont worry about it
too much forecasts of cash flows from the 6
th
year in the future into infinity are not easy to
make. Keep in mind: if no terminal value is included in the forecast, the valuation will be
based on the assumption that the business vaporizes at the end of the 5
th
year that no
cash flows occur from that point on.

1. The estimated liquidation value of the business at the end of year 5 is one
alternative to the growing perpetuity method. The quickest way to estimate
liquidation value is to use net worth, Q87 on the LFFM. If you want to do this,
enter 0% as growth rate in G10 and enter liquidation value in G24 overriding
the growing perpetuity formula in that cell.
2. A market multiple of revenue, EBIT, net income, or book value of equity is
another alternative to the growing perpetuity method. Market multiples are
discussed in the next section. If you want to do this, enter 0% as the growth rate
in G10 and enter the result of the market multiple calculation in G24 overriding
the growing perpetuity formula in that cell.

Market Multiples Equity Valuation Model

Financial analysts use the market multiples model as a substitute for, or as a
supplement to, the free cash flow valuation model. Data from publicly held peer

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companies in the same industry are used as a means of comparison. Market multiples
are sometimes called comparables.

The free cash flow model does not claim to be a mirror for how the market values a
company at a given time; it represents a belief about value based on parameters
plugged into a template: cash flows, growth rates, and discount rates, generating a fair
value, also called an intrinsic value, that can be above or below current market price.

Alternatively, application of market multiples on companies similar to the firm under
analysis offer a more direct measure of prevailing market value if the peer companies
are valid comparators and the data represent current market conditions (both conditions
are often violated). The belief is, if a share of Company X stock, in the same industry as
the business being valued, has a market price equal to 16 times its net income, then the
company being valued should also sell at the same market multiple 16 times its net
income

Calculate market multiples

Four types of market multiples are most commonly used. Each of them comes from a
ratio, with the market price per share of the peer company in the numerator, and one of
four parameters from the peer company in the denominator, generating the market
multiple:
1. market price per share of peer company earnings peer share of peer company
2. market price per share of peer company revenue peer share of peer company
3. market price per share of peer company EBITDA
8
per share of peer company
4. market price per share of peer company book value of equity per share of peer
company

Calculate equity value using market multiples

Then, using the market multiples as calculated above, each market multiple is multiplied
by each of the four parameters of the company being valued, as follows:
5. Market multiple for revenue x revenue per share of target company
6. Market multiple for EBITDA multiple x EBITDA per share of target company
7. Market multiple for net income x earnings per share of target company
8. Market multiple for book value of equity x book value of equity per share of target
company

The Market Multiples Valuation template is shown below.

1. Enter peer market multiples in A39.G42. There is room for five publicly held peer
firms of Universal Industries, the target firm, labeled Peer A through Peer E.
Usually the market multiples can be obtained from published sources. If the
sources offer only one or two of the market multiples, not all four, its okay to
leave the others blank, even though the analysis is less thorough. Alternatively,
use peer financial statements and calculate the market multiples yourself,
following the first 4 steps above a good idea because you control the
numerator and denominator and know for sure how each multiple is derived. Find

8
If EDITDA data is not available, use EBIT and note the change in the Market Multiples Valuation Template.

104
share price data on Yahoo Finance; you can usually find market multiples there
too.
2. Excel calculates the average of each market multiple in G39.G42. If you do not
enter data for all five peers, adjust the function computing the averages, so you
do not average in zero values.
3. Enter data for Universal, the target company, in A44.B49, from the LFFT or its
historical financial statements. Multiples can be based on the most recent
historical data, at the end of 2011 in this example, or on forecast data. Be
conservative, use historical data, but be aware that analysts sometimes use
forecast data instead. Entries in B45.B49 come from LFFM F8, F18, F27, F87,
and F39.
4. A51.E57 shows the market multiples calculations done by Excel. First, notice that
the target companys data are copied into B54.57. Second, notice that the
average market multiples are copied into C54.C57. Next, the average market
multiple is multiplied by target company data, column B times column C, giving
the aggregate valuations in D54.D57.
5. E54.E57 divides column D by the number of shares in B49, giving the per share
valuation. If you dont know the number of shares of the target company, thats
okay. Stating the aggregate value of 100% of the shares tells you what you
need to know.

The average of the four resulting values is 25.91 EUR per share, about 30% above the
19.87 EUR intrinsic value estimated from the free cash flow model. Notice that the
results of the Free Cash Flow model and the Market Multiples model are not mutually
confirming. The range of values suggested by the four different multiples is wide, from
12.89 EUR per share using Price/EBITDA market multiple to 42.43 EUR using
Price/Revenue. With a current market price of 15.25 EUR at the end of 2011, we can
draw the conclusion that Universal shares are undervalued. Only the EBITDA multiple
suggests otherwise with its valuation of 12.89 EUR.

Reconcile Conflicting Results of Free Cash Flow and Market Multiples Models

This chapter began by warning you about the tentative nature of equity valuation. What
might appear to be a scientific approach, using Excel modeling, is a highly subjective
and impressionistic process where the analyst has wide discretion to decide about the
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A B C D E F G
MARKET MULTIPLES (COMPARABLES) VALUATION OF EQUITY
Average
Market Multiples of Peers Peer A Peer B Peer C Peer D Peer E Mkt Mult
Price /revenue market multiple of peer company 4.0 5.0 6.0 10.0 1.0 5.2
Price/EBITDA market multiple of peer company 14.0 12.0 18.0 20.0 6.0 14.0
Price /Earnings market multiple of peer company 23.0 35.0 41.0 60.0 6.0 33.0
Mkt Val of Eq/Book Val mkt mult of Equity of peer co 5.0 8.0 10.0 14.0 1.0 7.6
Target company data
Target company revenue 1224.0
Target company EBITDA 138.1
Target company earnings (net income) 105.3
Target company book value of equity 496.2
Target company number of shares 150.0
from col B from Col G BxC C/B55
Target Co Average Aggregate Per Share
Valuation Calculations Data Mkt Mult Valuation Valuation
Valuation based on avg revenue market multiple 1224.0 5.2 6364.80 ! 42.43
Valuation based on avg EBITDA market multiple 138.1 14.0 1933.40 ! 12.89
Valuation based on avg earnings market multiple 105.3 33.0 3474.90 ! 23.17
Valuation based on avg book value market multiple 496.2 7.6 3771.12 ! 25.14

105
inputs driving the valuation. You can picture the valuation analyst either as a scientist in
a white lab coat, or as an artist, like the ones below.



Abstract Artist Don Tywoniw don2d@comcast.net www.2Dgraphics.net
The table below arrays the results from both models and includes the current market
price. If you throw out the extremes, 42.43 and 19.87, you are left with a cluster in
column D averaging 24.74, a valuation that is 25% above the current market value. You
can decide to trust this result or not, depending on your confidence in all the inputs you
made to the models, and your general knowledge about the economy, industry,
company, and financial markets. Valuation is not an easy job!



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A B C D E F
Summary map
FREE CASH FLOW MODEL 25.91
REVENUE MARKET MULTIPLE 42.43
EBITDA MARKET MULTIPLE 12.89
EARNINGS MARKET MULTIPLE 23.17
BOOK VALUE MARKET MULTIPLE 25.14
CURRENT MARKET PRICE 19.87

106

Nine Elements in the Equity Valuation Process
A Summary

Following is a listing of the nine elements found in generally accepted equity valuation
methodology. It revisits many of the topics already presented in this book. Use them to put
the results of the FCF and Market Multiples models in perspective.

1. Nature and history of the business is the historical financial statements and
ratios along with descriptions of the business, its products, markets,
competitors, suppliers, managers, successes, failures, problems, opportunities,
and plans.
2. Future outlook for the business is the forecasted financial statements based
on perceived growth in the economy, which determines the growth in the
industry, and therefore determines the growth for the company. This is called a
top-down analysis because it starts broadly with macroeconomic factors and
ends narrowly with company revenue, profit, and cash flow. These are the
components of business risk, also called operating leverage, describing how
variations in unit volume and revenue prices filter through cost of sales and
operating expenses to determine changes operating profit.
3. Financial status examines financial risk, also called financial leverage,
through debt and coverage ratios. It describes how changes in operating profit
filters through interest expense, taxes, and number of shares outstanding to
determine changes earnings per share.
4. Future earning capacity is the quality of the cash flow, i.e., its predictability
and stability over time.
5. Dividend payment capacity is the desire and ability to continue to pay
dividends.
6. Goodwill covers other factors such as brand names, competitive ability, market
penetration, technological advantages and patents, and management skills that
may have a bearing on value.
7. When shares are not publicly traded, recent private share transactions, if
any, in the same company can be used as a guideline for valuation. If no recent
transactions occurred, transactions in similar companies can provide guidelines
in terms of discount rates, price/earnings multiples, and other valuation data.
8. Redundant assets that can be sold without influencing the ability of the
business to generate its revenue and cash flow should be added to the equity
value.
9. Control block transactions may involve premiums of 20% or more.



107

CHAPTER 7
DEBT VS. EQUITY FINANCING
&
LEASE VS. BORROW-TO-BUY ANALYSIS


The Debt vs. Equity Decision

Financial Leverage and Debt Capacity

Now we examine how a business decides to obtain external financing from the capital
markets, using either debt or equity. The key question is how much money can be
prudently borrowed? Most businesses view their plant capacity as a resource not to be
wasted there is little disagreement about that. They may also view their ability to
borrow, their debt capacity, as a resource, believing that it should be used to its full
extent, just like they want to use their plant capacity to its full extent.



The IS/BS Model shows you where this chapters material fits into the process of financial
decision-making. The red boxes of the balance sheet show debt and equity; the red boxes
of the income statement show the interest expense generated by debt; both are keyed to
the red label FINANCIAL LEVERAGE.


108


The red panels in the Flow Diagram depict the financing decision process consisting of
three parts:
1. the spreadsheet debt vs. equity analysis
2. the EBIT chart
3. the six-element decision summary



ANALYSIS STEPS: FINANCING DEBT EQUITY
1-HISTORICAL RATIOS DEBT
2-K-WACC HISTORICAL RATIOS I/S & B/S FORECAST EFN
3-CAPITAL BUDGETING
4-FORECAST & EFN
LONG-FORM FORECAST I/S, B/S, & RATIOS EQUITY
5-EQUITY VALUATION EBIT CHART
6-FINANCING
income risk control mktblty flexblty timing

CAPITAL BUDGETING OP & CAP NATCF, NPV, IRR, PAYBACK
K-WACC
VALUATION ENTERPRISE VALUE USING FREE CASH FLOW
MARKET MULTIPLES: P/E, MV/BV, REV, EBIT

109

Leverage is Gearing

In the picture below, the smaller gears drive the biggest one. The use of debt in a
companys capital structure is called leverage because a small base of equity (analogous
to the smallest gear in the picture) has debt financing added to it (the successively larger
gears) to provide that allows it to buy assets so they can produce their product or service.
In fact, in some countries, the United Kingdom among them, gearing is their term for
financial leverage.



Financial Risk Means Default Risk

Using debt means that financial risk looms in your planning. If you don't borrow, there are
no fixed interest payments to make and you don't have to repay any principal; there is no
lender to force you into bankruptcy; there is no financial risk. But, no use of debt financing
may be narrow-minded. By combining some debt financing with equity financing, the
owners can earn a higher rate of return than with 100% equity financing alone.

If you decide to play it safe, don't borrow at all, or borrow less. If you want to be aggressive,
borrow the maximum amount that lenders are willing to lend. Your potential rate of return
will be higher, but so will your risk. Whatever you decide to do, you must understand the
return/risk trade-off. You can eat well (high ROE & low coverage ratio) or sleep well (low
ROE & high coverage ratio), but not both. Always remember that the leverage created by
borrowing is a double-edged sword; the greater the proportion of debt relative to equity, the
more ROE increases as EBIT rises in good times, and the more ROE decreases as
operating profit falls in bad times.

A look at the Financial Ratios display from Chapter 3, below, shows you where the
leverage ratios come from rows 118, 103-107, and 124. You can zoom to 175% or
more or view it in Template Set.xls.





110

The table below illustrates the risk-return trade-offs involved with financial leverage.
Operating profit (EBIT) and total assets are the same in all examples, Companies A, B,
and C. Companies B and C use 40 of debt and 40 of equity; with financing cost of 8
(8%), where Company A has zero debt financing and zero financing cost. The
advantage of debt financing is that ROE changes from 25% for Company A to 35% for
Company B when 50% debt financing is used, illustrating positive financial leverage. On
the other hand, negative financial leverage is illustrated by Company C, when operating
profit falls to 15 from 25, ROE drops to 15% when it would have been 25% in Company
A with zero debt.




ROIC Is a Performance Metric Undistorted by Capital Structure Policy (Financing)

Examine three ways to measure rates of return in the table below:
ROE, row 15
ROA, row 16
ROIC, row 17

ROE rises from 7.2% with zero debt to 18.0% with 900 debt, although the 9:1 debt-equity
ratio can be considered extreme. The numerator deceases because of interest expense,
but the denominator decreases proportionally more.

COMPANY A B C
Revenue 100 100 100
Operating profit (EBIT) 25 25 15
Financing cost 0 8 8
Profit before tax 25 17 7
Tax 5 3 1
Net profit 20 14 6
Total debt 0 40 40
Total equity 80 40 40
Total debt + equity 80 80 80
Return on equity 25% 35% 15%
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A B C D E F G H
YEAR 2010 2011 TREND PRELIMINARY INTERPRETATION NUMERATOR DEMONINATOR
Liquidity Ratios
Current ratio 1.6 1.3 -21% negative, less liquidity current assets current liabilities
Quick ratio 1.1 0.8 -21% negative, less liquidity curr assets-inventory current liabilities
Days sales in receivables 75.4 56.3 -25% positive, quicker collections receivables revenue/365 days
Days cost of sales in inventory 59.9 54.0 -10% positive, faster turnover inventory cost of sales/365 days
Days cost of sales in payables 47.6 65.0 37% negative, paying more slowly payables cost of sales/365 days

Leverage Ratios
Long-term debt to total capital 57.9% 45.5% -21% positive, less financial risk l-t leases+loans+debt l-t leases+loans+debt+equity
Long-term debt to equity 137.4% 83.5% -39% positive, less financial risk l-t leases+loans+debt equity
Times interest earned 1.8 3.8 109% positive, better coverage operating profit (EBIT) finance costs
Full burden coverage 1.5 3.1 107% positive, better coverage oper profit + lease exp finance costs + (lease exp/[1-tax rate])

Efficiency (Asset-Use) Ratios
Fixed asset turnover 1.2 1.4 19% positive, faster turnover revenue total non-current assets
Total asset turnover 0.8 1.0 21% positive, faster turnover revenue total assets

Profitability Ratios
Gross margin 23.9% 34.9% 46% positive, big improvement gross profit revenue
Operating profit margin 6.8% 11.3% 65% positive, bigger improvement operating profit (EBIT) revenue
Return on sales 2.7% 8.6% 216% positive, still bigger improvement net profit revenue
Return on total assets(ROA) 2.2% 8.5% 283% positive, still bigger improvement net profit total assets
Return on equity (ROE) 6.8% 21.2% 212% positive, big improvement net profit equity
Return on invested capital (ROIC) 4.7% 9.4% 100% positive, big improvement EBIT*I1-tax rate) total assets

DuPont Formula - ROE 6.8% 21.3% 212% profitability x efficiency x leverage
Profitability 2.7% 8.6% 216% positive, big improvement net profit revenue
Efficiency 0.8 1.0 21% positive, better turnover revenue total assets
Leverage 3.1 2.5 -19% positive, less financial risk total assets equity
ROE Check 6.8% 21.2% 212% calculation check to verify row 121 net profit equity

111
ROA decreases from 7.2% with zero debt to 1.8% with 900 debt, because interest expense
reduces the numerator and has no impact on the denominator.

ROIC is the same, 7.2%, no matter how much of how little debt financial is used, because
interest expense and equity are not part of the calculation.

When you need a rate of return metric that is independent of the financial structure of the
business, use ROIC. It removes the distortion in the ROE and ROA metrics.




The Leahy Bread Company Case

The standard financing decision uses the forecasted external financing required combined
with an analysis to determine whether that financing should be raised with debt or equity.
Lets dig into the analysis using the fictional example of Leahy Bread Company (LBC).

Learning objectives:
1. Perform the debt versus equity analysis as depicted in the Flow Diagram
2. Prepare and interpret an EBIT chart highlighting the indifference level of EBIT
3. Determine the debt capacity
4. Consider the numerous, sometimes conflicting elements in the financing
decision as summarized by the FRICTO acronym income, risk, control,
marketability, flexibility, and timing.
5. Make the debt vs. equity decision

The LBC forecast below results in external financing need (EFN) of $392,675 (F79 of the
forecast) to fund a major expansion plan. There are two ways to raise the money:
1. a 9% bond, with a 20-year maturity, and a balloon payment of $392,675 at maturity
2. a stock issue of 3,927 shares at $100 per share.

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9
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A B C D E F
Interest rate 10% 10.0%
Tax rate 40% 40.0%
COMPANY A COMPANY B
Debt 900 0
Equity 100 1000
TOTAL ASSETS 1000 1000
EBIT 120 120
- Interest expense 90 0
Earnings before tax 30 120
- Tax @ 40% 12 48
Earnings after tax 18 72
Numerator Denominator
ROE 18.0% 7.2% RETURN ON EQUITY Earnings after tax Equity
ROA 1.8% 7.2% RETURN ON ASSETS Earnings after tax Total Assets
ROIC 7.2% 7.2% RETURN ON INVESTED CAPITAL EBIT * (1-Tax rate) Total Assets

112

What comes next shows you, one step at a time, the financing decision process as
depicted in the red boxes on the Flow Diagram:
1. find EFN
2. complete the financing spreadsheet
3. interpret the EBIT chart
4. determine the indifference point
5. measure the debt capacity
6. consider FRICTO elements
7. make the decision

The Financing Template is shown below; it evaluates the two financing alternatives, debt or
equity. It is much simpler than it looks at first glance. The template creates a set of mini
income statement forecasts, two for each of the two financing alternatives, debt and equity,
one under a boom scenario and the other under a bust scenario.


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A B C D E F
2012 2013 2014 2015 2016
Revenue 1,155,000 1,270,500 1,524,600 1,981,980 2,576,574
Costs of Goods Sold
Bakery Caf 750,750 825,825 990,990 1,288,287 1,674,773
Dough Sold to Franchisees 138,600 152,460 182,952 237,838 309,189
Depreciation 57,750 63,525 76,230 99,099 128,829
General and Administrative (c) 92,400 101,640 121,968 158,558 206,126
1,039,500 1,143,450 1,372,140 1,783,782 2,318,917
Operating Profit (EBIT) 115,500 127,050 152,460 198,198 257,657
Interest Expense 21,000 21,000 21,000 21,000 21,000
Pretax Profit 94,500 106,050 131,460 177,198 236,657
Tax 33,075 37,118 46,011 62,019 82,830
Net Income 61,425 68,933 85,449 115,179 153,827
Current Assets 196,350 215,985 259,182 336,937 438,018
Property, Plant, and Equipment 485,100 533,610 640,332 832,432 1,082,161
Goodwill and Other Assets 115,500 127,050 152,460 198,198 257,657
Total Assets 796,950 876,645 1,051,974 1,367,566 1,777,836
Current Liabilities 138,600 160,962 193,154 251,100 326,430
Deferred Rent and Other Liabilities 46,200 59,296 71,155 92,501 120,252
Total Liabilities 184,800 220,258 264,309 343,602 446,682
Debt 0 0 0 0 0
Equity 515,091 584,024 669,473 784,651 938,479
Total Liabilities and Equity 699,891 804,281 933,782 1,128,253 1,385,161
EFN 97,059 72,364 118,192 239,313 392,675

113

Follow these steps to perform the analysis.

1. Enter EFN from F79 in the forecast to B3 in the financing template. The forecast is
shown above.
2. Enter existing number of shares, 7,500, in B4. Use the number of shares
outstanding at the end of the most recent historical period.
3. Enter 300,000 existing long-term debt in B5. Use the most recent historical amount.
4. Enter in B6 the interest rate on the amount of long-term debt in B5. It can be
estimated by dividing interest expense by long-term debt as long as there is no
short-term debt. Alternatively, the company annual report reveals the interest rate.
Use the most recent historical time period.
5. Enter the interest rate on prospective new debt in B7. It is given.
6. Decide what the lowest and highest possible levels of EBIT will be over the planning
horizon; to identify the boom and bust extremes of EBIT. They are the same for
both financing alternatives, entered in B8 and B9 using rounded arbitrary numbers
below the lowest EBIT and above the highest EBIT figures from the LBC forecast
on row 59. (If the EBITs you enter have too narrow a range between the high and
low, the EBIT chart will not display the necessary range of numbers more on this
is discussed later.)
7. Enter the income tax rate, 35%, in B10, using the most recent historical data.
8. Enter current share price in B11.
9. Enter stockholders equity in B12 from the most recent historical time period.

Results are automatically calculated by formulas in the template. Notice the mini income
statements that are calculated, especially that:
10. Existing (old, before new debt financing) interest expense on row 17 is the same for
all four scenarios. Only the debt scenarios have new interest expense, on row 18.
11. The existing number of shares on row 22 is the same for all four scenarios. Only the
equity scenario has new shares, on row 23. New (after new equity financing)
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A B C D E F
FINANCING (DEBT-EQUITY) DECISION Leahy Bread Company
Inputs:
External Financing Needed 392,675 from forecast
Existing Common Shares 7,500 from company info
Existing Long-Term Debt 300,000 from most recent historical balance sheet
Interest on Existing Debt 7.0% from company info
Interest Rate on New Debt 9.0% given
Boom EBIT 300,000 arbitrarily above optimistic forecast
Bust EBIT 50,000 arbitrarily below pessimistic forecast
Income Tax Rate 35.0% from income statement
Share Price 100.00 $ from market info
Equity 528,741 from most recent historical balance sheet
Results: IF DEBT IS USED IF EQUITY IS USED
BOOM BUST BOOM BUST
EBIT 300,000 50,000 300,000 50,000
Interest expense - old (21,000) (21,000) (21,000) (21,000)
Interest expense - new (35,341) (35,341) 0 0
Profit before tax 243,659 (6,341) 279,000 29,000
Income tax (85,281) 2,219 (97,650) (10,150)
Net profit 158,379 (4,121) 181,350 18,850
Shares 7,500 7,500 7,500 7,500
Shares - new 0 0 3,927 3,927
Earnings per share 21.12 $ (0.55) $ 15.87 $ 1.65 $
Coverage ratio 5.3 0.9 14.3 2.4

114
number of shares on row 23 is the amount of money raised divided by the expected
issue price of $100 per share.
12. The debt ratio is calculated by (old + new debt) divided by (old + new debt + equity).
13. The coverage ratio is calculated by EBIT divided by total interest (old + new).


EBIT Chart

Excel creates an EBIT Chart using some the data calculated in the 12 steps above:



It plots EBIT on the horizontal axis and EPS on the vertical axis. A wide-enough range
between low and high EBIT is necessary; otherwise, the lines will be truncated and the
point where the two lines cross, called the indifference level of EBIT, will not be displayed.
Its easy to draw an EBIT Chart by hand, so you see exactly where it comes from:
1. plot low EBIT and debt EPS
2. plot high EBIT and debt EPS, then draw a line between the points the debt line
3. plot low EBIT and equity EPS
4. plot high EBIT and equity EPS, then draw a line between the points the equity line

EBIT 50000 300000
debt EPS ($0.55) $21.12
equity
EPS $1.65 $15.87

Notice that the debt line is steeper than the equity line because use of debt financing
causes EPS to change at a greater rate as EBIT changes the essence of financial
leverage. Notice also the double-edged sword aspect of financial leverage as the lines
diverge from the indifference level the gap between EPS with debt and EPS with equity
widens. The right-hand divergence is good - financial leverage helps. The left-hand
divergence is bad financial leverage hurts.

EBIT CHART
($5.00)
$0.00
$5.00
$10.00
$15.00
$20.00
$25.00
50000 300000
EBIT
E
P
S
debt EPS
equity EPS

115
There is no time dimension involved in creating the EBIT Chart. No specific year is
specified. Its purpose is to display the EBIT-EPS relationship for any level of EBIT in any
year.

Indifference point

The indifference point is the amount of EBIT where EPS is identical, whether the new
financing comes from debt or equity. Interpret this narrowly company managers and
owners will not be indifferent about the other FRICTO elements of the decision, discussed
below. Indifference in the context of the EBIT Chart relates only to EBIT driving EPS.

The numerical indifference point can be guestimated by looking at the EBIT Chart. A more
accurate indifference point is calculated in the table below:


The indifference point is EBIT of $123,841 giving earnings per share of $5.85 for both the
debt and the equity scenarios.
9
From the forecast on page 112 at the beginning of this
section, you can see that the EBIT ranges from $115,500 to $257,657. The indifference
EBIT is about 7% above the low EBIT, and about 123% below the high EBIT. Interpreting
the result depends on the probabilities of future EBITs falling either above or below
$123,841. If managers believe that most-likely EBIT will be comfortably above the
indifference level, the EBIT chart tells them to use debt financing, and vice versa.
Remember: only the EBIT and EPS elements of the financing decision are considered
here. The other FRICTO elements are discussed below. Keep reading!


Debt Capacity

How much debt can a business carry? Getting to the answer, which is a matter of
opinion to some extent, is deceptively simple, using the model below:




9
The indifference level can be found using the FINANCING template alone by trial-and-error. Enter amounts for Bust EBIT
until you get the same earnings per share results for both debt and equity alternatives.
48
49
50
51
52
53
54
55
56
57
58
59
A B C D E
Indifference point calculation:
Debt Equity
Common shares 7,500 11,427
Income tax rate 35.0% 35.0%
Interest expense 56,341 21,000
EBIT 123,841 123,841 Indifference EBIT
Interest expense 56,341 21,000
EBT 67,500 102,841
Income tax 23,625 35,994
EAT 43,875 66,846
EPS 5.85 $ 5.85 $ Indifference EPS

116


Follow this step-by-step example:
1. A range of EBITs is entered in row 64, using bust, boom and indifference levels.
2. Enter 5.9 in row 65 because managers decide to plan for a BBB credit rating,
which carries an interest coverage ratio of 5.9 times according to this table:


3. In row 66, Excel plugs the EBIT and interest coverage numbers into the interest
coverage formula: EBIT divided by interest expense equals coverage ratio. The
result is the amount of money that is available to pay interest expense.
4. In row 67, enter the 9% interest rate given. If none is given, use a current rate
that matches the credit rating chosen.
5. In row 68, using the interest rate on BBB-quality debt of 9% per year, Excel
divides 9% into the amount available for interest (grossing it up). The result is the
debt capacity of the business the amount of borrowing that can occur based on
EBIT, the coverage ratio, and the interest rate. Of course, different inputs give
different results thats why the measuring debt capacity is subject to opinion
about which inputs should be used.
6. Enter in row 69 the amount of existing long-term debt from the most recent
historical balance sheet.
7. In row 70, Excel subtracts existing long-term debt from overall debt capacity to
get the amount of excess debt capacity, how much is available for new debt
financing. A negative number means that debt capacity is exhausted, because
existing debt exceeds overall debt capacity, i.e., the business has already
borrowed too much.

All calculations above assume that only interest expense is paid each year that no
principle payments are paid. If both principal and interest must be paid each year, the
calculation becomes more complex debt capacity becomes the present value of an
annuity where the periodic payment is the EBIT available to pay it, considering the
coverage ratio required, adjusted for the fact that interest expense is paid in pre-tax
dollars and principal is repaid in after-tax dollars. For example, if the tax rate is 35%, and
the principal payment is $10,000, it takes $15,385 of EBIT to pay $10,000 of principal,
$10,000 divided by (1-.35). Because EBIT is paid from pre-tax dollars, $10,000 of EBIT
is needed to pay $10,000 of interest.

67
68
H I J K L M N O
AAA AA A BBB BB B CCC
Interest coverage ratio 27.3 18 10.4 5.9 3.4 1.5 0.5
62
63
64
65
66
67
68
69
70
A B C D E F
Debt capacity calculation:
Bust Boom Indiff.
EBIT 50,000 300,000 123,841
Interest coverage ratio per rating 5.9 5.9 5.9 BBB rating chosen
AVAILABLE FOR INTEREST 8,475 50,847 20,990
Interest rate 9.0% 9.0% 9.0%
DEBT CAPACITY 94,162 564,972 233,222
Existing debt 300,000 300,000 300,000
EXCESS DEBT CAPACITY -205,838 264,972 -66,778

117
It is easy to estimate the debt capacity of a business, even though the resulting number
is best interpreted as an approximation. Whether decision makers want to push debt to
the limit, or use it conservatively, is a choice they have to make based on their
confidence in the financial forecasts and their appetite for risk, as well as the full set of
FRICTO elements in the financing decision, to be discussed next.

Summarizing the LBC financing decision with FRICTO

In making a decision about which financing alternative to use, the results in the financing
template are interpreted by considering the trade-offs between these six elements in the
financing decision. Using the first letter of the alphabet for each element, we get the
acronym FRICTO (marketability as other):
1. flexibility
2. risk
3. income
4. control
5. timing
6. marketability:
10


The flexibility element deals with two things:
1. First, and easiest to appraise, are restrictive covenants and repayment schedules
included in the loan contract. For instance, diverting cash from research and
development or plant modernization to payment of principal may not be desirable.
Also, restrictive covenants on levels of net working capital, purchase of assets, and
payment of dividends limit the freedom of management action. Violation of any
covenant may place the loan contract in default.
2. The second type of flexibility deals with the belief that the financing taking place
now will not be the last one for this company, as it continues to grow. If it decides to
use debt now, its debt ratio rises and coverage ratio fall. Then, the next time it
needs external financing, equity may be the only choice because it may have
exhausted its capacity to borrow. If the market price of its shares is falling, issuing
equity would cause too much dilution of EPS and control. It would be a mistake if
the financial managers forced themselves to use equity financing in the future,
without realizing the possible adverse consequences in advance. There is nothing
wrong with following an aggressive financing policy, using debt financing, but
managers should always consider present external financing needs in the
perspective of ongoing external financing needs.

The marketability element deals with the ability to sell the debt or equity securities to
investors. The terms of the issues must be acceptable to the marketplace. Investors judge
whether the rate of return they expect to earn is consistent with the risk involved and with
the rates of return available on similar securities.

The timing element deals with market trends. Ideally, new permanent borrowing would
occur when interest rates are historically low, and a new equity issue would occur when
prices are historically high. As difficult as it is to do, the decision maker must consider the
current interest rate environment in relation to an interest rate forecast, and decide if the
company can accept fixed rate financing now. It may be possible to add a refinancing
clause to the debt contract, allowing for the right to repay principal before the maturity date

10
The FRICTO analysis was developed by finance professors at the Harvard Business School in the 1960s.

118
without penalty if interest rates fall. It could then issue new debt at a lower interest rate,
replacing the higher-rate debt. Of course, by insisting on the right to refinance, marketability
of the issue may be reduced. Many investors are wary of refundable debt instruments
because they are forced to reinvest at lower interest rates.

The control element deals with voting rights. If an equity issue places a controlling interest
in jeopardy, debt may be considered as better than equity. In small companies, this factor is
given a great deal of weight. You should be careful about allowing the control factor alone
to push you in the direction of a debt financing decision. It may be short-sighted to incur the
risk of debt financing when avoiding dilution of control is the only reason for it.

The income and risk elements are interpreted from the EBIT Chart, discussed above, and
interest coverage ratios in the financing template. You already know that EBIT drives EPS,
therefore, the steepness of the lines depends on the extent of financial leverage used,
portraying the magnified impact on EPS that occurs when EBIT increases or decreases.

The income element is measured with EPS. Assuming a boom level of EBIT, EPS is
highest for debt and lowest for equity. The reverse is true assuming a bust level of EBIT.
The intersection of the two lines, called indifference point, shows the level of EBIT where
earnings per share is identical whether debt or equity financing is usedall other things
equal, it makes no difference whether debt or equity financing is used at this EBIT level
because EPS is the same either way. Moving to the right of the indifference point, EPS for
the debt scenario is greater than that for the equity scenario. Moving to the left of the
indifference point, the reverse is true. Therefore, by identifying the most likely level of EBIT
in the future, the decision maker can tell which financing alternative offers better EPS. The
greater the spread between the debt and equity lines, depending on their relative
steepness, the greater is the impact of financial leverage. Always remember: Leverage is a
double-edged sword; it cuts two ways. To the right of the indifference point, financial
leverage is beneficial all other elements equal. To the left of the indifference point, it is
detrimental.










119


The table below puts the sometimes-conflicting signals from the FRICTO analysis in one
place. Some elements favor debt; others favor equity.

Decision Elements Metric Debt Financing Equity Financing
Flexibility Future EFN Lower favors equity More favors equity
Risk Slope of lines on
EBIT Chart &
indifference point,
interest coverage
ratios, excess
debt capacity
available, dilution
of EPS
Greater favors
equity
Lesser favors
equity
Income EPS, slope of
lines on EBIT
Chart &
indifference point
Greater favors debt Lesser favors debt
Control Dilution of voting
control
Minimal dilution
favors debt

Significant dilution
favors equity
Timing Current interest
rates & stock
price relative to
trends
Reasonable interest
rate relative to trend
favors debt
Undervalued stock
price favors debt
(O) Marketability Terms of debt
and equity issue
and investors
interest
Willingness of debt
investors to buy the
issue
Willingness of equity
investors to buy the
issue

Play the findings of each of the six elements off of one another.
Could EBIT in the future easily fall below the $123,841 indifference level? One
manager might prefer equity instead of debt a conservative, risk-averse
recommendation. Another might use exactly the same information and recommend
debt because her forecast of future EBIT is more optimistic and wants to take a
more aggressive stance.
Look at the trend of EBIT in the forecast and consider the probability of it falling
below $123,841. EBIT in 2012 is forecast at $115,500, below the indifference point;
2016 EBIT of $257,657 is above the indifference point. How many years before
EBIT exceeds the indifference level? According to the forecast about one year.
But, by 2016, EBIT is more than double the indifference level, where on the low
end, it is only about 8% below the indifference level. If they trust the forecast, many
managers would favor debt financing; especially those with an optimistic outlook
and an aggressive attitude about risk.
Those favoring the equity alternative might have a pessimistic interpretation of the
forecast, having a conservative, risk-averse attitude. Obviously, the risk of default is
higher with debt financing, confirmed by the coverage ratio of 0.9 times for the bust
level of EBIT.

120
Flexibility is greater with the equity alternative because excess debt capacity is still
available for the next round of financing, as LBC continues its growth strategy,
another interpretation favoring equity financing. Excess debt capacity is negative for
both the bust and indifference level scenarios, indicating that they already have too
much debt.
Debt financing almost always maintains the control position because if equity is
issued, each existing shareholder owns a smaller percentage of the company after
an equity issue than before, incurring dilution.
Lets assume that investment bankers are equally able to sell a debt issue or a
stock issue, so the marketability element is neutral.
Considering timing, if a 9% interest rate on debt is considered a fair rate for the next
20 years, then the timing of a debt issue is favorable. Similarly, if the $100 issue
price for the stock is on the high end of the stocks recent trading range, then the
timing of the stock issue is favorable.

What is the correct decision? Should it be debt or equity financing? There is no such
correct answer. It depends on judgment by the people involved in the decision, their
interpretations of the analysis resting on the believability of the forecasted data, and their
attitudes toward growth and risk. While there may be no correct decision, there is certainly
a correct analysis. Competent managers are guided by a complete analysis laying out both
upside and downside possibilities. There is nothing wrong about following a risky path if the
possible downside is clearly understood when the decision is made.


Closing Comments:
Cost of Debt vs. Cost of Equity

Chapter 5 discussed the use of Weighted Average Cost of Capital as the discount rate in
capital budgeting model. Chapter 6 used Weighted Average Cost of Capital as the
discount rate in the Free Cash Flow Equity Valuation model. That is depicted in the
IS/BS Model where cost of debt and cost of equity come together to calculate k-wacc;
and depicted in the Flow Diagram where the k-wacc panel is tied to the capital budgeting
and equity valuation boxes.

Lender: From the viewpoint of the creditor, lending money to a company is a less risky
investment than buying shares in that company. The lender is a creditor with a contractual
right to receive a specific amount of interest at specific dates and to receive the face
amount at the maturity date.

Owner: The shareholder is an owner, who benefits during good times and who looses
during bad times.

Lender vs. Owner: Therefore, the lender requires a lower rate of return because he or she
takes less risk in lending than the shareholder does in owning. A lower rate is used to
discount cash flows going to lenders than the one used to discount cash flows going to
shareholders. K-wacc represents the weighted average of two discount rates, one for
lenders, the other for owners, so it is interpreted as an average rate of return that goes to
both categories of capital suppliers, lenders and owners.


121
One warning must be cited at this point. There is little difficulty realizing that debt has a
cost. This is the interest rate paid on an after-tax basis to borrow the money, k-d. But, does
equity have a cost? After all, if no dividends are paid, you might say that it does not cost the
company anything. But to say that is wrong, because it violates the principle of every risk
having an appropriate rate of return. Even though the company might never pay a dividend
to a shareholder, that shareholder still requires a rate of return, which is k-e. Never fall into
the trap of thinking that equity costs less than debt because it does not pay anything to its
shareholders.

One more aspect of cost of equity must be clarified. Do retained earnings (accumulated
profits) have a cost, or are they free? Their cost is similar to cost of equity. The company
must justify reinvesting profit in the business by earning a sufficient rate of return for
shareholders, k-e. Retained earnings has a cost just as every other source of financing
has a cost.

The Lease vs. Borrow-to-Buy Decision

Leasing is a form of financing which serves as a substitute for borrowing money to
purchase fixed assets such as buildings, production equipment, motor vehicles, office
equipment, and tools. Once you decide that the acquisition of a fixed asset is justified by its
payback period, net present value or internal rate of return, i.e., the investment decision in
Chapter 5, you have completed only the first step. The second step is to decide whether to
lease it or to buy it with borrowed money, i.e., the financing decision.

Normally, the after tax cost of debt, k
d
, is used to discount the cash flows in a lease/buy
analysis. Since the cash flows are determined by a lease contract or a loan agreement,
they are not subject to much variation, and should be discounted without any risk
adjustment related to the higher cost of equity. The analyst might decide to use a different
rate for discounting the residual value at the end of the time horizon, because these
amounts are not determined by contract and depend on market conditions in the future.

In a capital budgeting (investment) decision, only the cash flows for purchasing the asset
and operating the asset were considered, as discussed in Chapter 5. Cash flows for
financing cost and repayment of loan principal are never included in an investment
decision. But, because the lease/buy decision is a financing decision rather than an
investment decision, cash flows for financing cost and repayment of loan principal are the
important numbers in the analysis. The operating cash flows for an asset are the same no
matter whether the asset is leased or bought, so they have no impact on the lease/buy
decision and are disregarded in the analysis.

Purpose of the analysis

The purpose of the lease/buy decision is to select the alternative with the lowest after tax
cash outflow. The use you receive from the asset will be the same, whether it is leased or
bought. The analysis shows you which method of acquisition is least expensive; the lower
the present value of the net cash outflow, the better.


122

Layout of the analysis

Use the LEASE VS. BORROW-TO-BUY template in the table below for this analysis.
Universal Industries, Ltd. is ready to purchase a new machine at a net price of 10,000 euro.
The machine has already been approved using the capital budgeting process discussed in
Chapter 5. The vendor of the machine is ready to sell it or lease it, either way. If Universal
Industries buys the machine, it will borrow the funds from a commercial bank for a 5-year
term at an interest rate of 9%. Alternatively, a leasing agent is vigorously suggesting that
Universal Industries can conserve its cash and borrowing capacity by leasing the machine
rather than buying it, at an annual lease fee of 2,500 euro for 5 years. At the end of the 5
years, the machine becomes the property of the leasing company. Universal Industries
estimates the residual value of the machine at the end of 5 years to be 2,000 euro.
Whether Universal Industries leases or buys the machine, the operating expenses are
exactly the same; the only differences are the financing costs - lease or buy.

Input data:
1. Enter the cost of the equipment, economic life, annual straight-line depreciation,
annual lease payment, and residual value in rows 4-8.
2. Enter the income tax rate in row 9.
3. Enter the interest rate on the loan, 9%, in row 10.
4. Enter the loan amount on row 11.

Analysis of loan:
5. The amount of the loan is netted against the price of the equipment, allowing for a
down payment, in C21, which does not occur in this example.
6. The loan is interest-only; the principal is repaid at the end of the loan period. The
tax shield on the interest expense in row 17 is calculated by multiplying the tax rate
times interest expense. Each euro of interest expense saves 0.156 euro in taxes.
7. Interest expense is a cash outlay. The tax shield on row 19 is a cash inflow because
the income tax bill is reduced because of this transaction.
8. The depreciation tax shield is calculated by multiplying the tax rate by depreciation
expense, shown as a cash inflow on row 20. Notice that no depreciation expense is
deducted in the analysis because it is a not a cash flow. Only the tax shield on the
depreciation expense is a cash flow.
9. Row 21 sums the net after tax cash flows.
10. Row 22 gives the present value of the Net After Tax Cash Flow (NATCF) using a
discount rate of 7.6%, which is the after-tax interest rate .09 * (1-.156).
11. To make the lease flows and the loan flows comparable, you terminate both of them
at the end of the 5
th
year. You assume exactly five years of service from the
machine under either alternative. The lease flows terminate at the end of the lease
period, and the leasing agent keeps the machine. For the loan, you enter a terminal
inflow for the value of the machine at the end of the 5
th
year, estimated to be 2,000
euro, assuming that you can sell it for that amount at that time. If the sale causes a
taxable gain, the residual value is reduced by the amount of the gain.

123
Lease vs. Borrow-to-Buy Template

Analysis of lease:
12. Row 32 calculates the tax shield on the lease payment. The tax shield is the
amount of income tax not paid because the lease payment is a tax deductible
business expense. It is calculated by multiplying the tax rate by the lease payment.
13. Row 33 gives the NATCF for the lease. Then, the present value of the NATCF is
calculated in C34.

The lowest present value is the best deal, because it represents the smallest cash outlay to
get the use of the equipment. Both present values are negative because the analysis is
based on cash outlays to service the loan and the lease. The lease has a PV of (6,873)
euro, cell C34, and the buy has a PV of (6,489) euro, cell C22, making the lease alternative
more expensive by 384 euro. However, the decision may rest on the present value of the
2,000 euro residual flow in year 5, which is not a contractual flow as are the lease
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
32
33
34
35
36
37
38
39
40
A B C D E F G H
LEASE vs. BORROW-TO-BUY ANALYSIS
INPUT DATA
COST OF EQUIPMENT 10,000
ECONOMIC LIFE 5
S-L DEPREC 2,000
LEASE PAYMENT 2,500
RESIDUAL 2,000
TAX RATE 35.0%
INTEREST RATE 9.0%
LOAN AMOUNT 10,000

BORROW TO BUY ANALYSIS
PERIOD 0 1 2 3 4 5
PRICE -10,000
LOAN 10,000
INTEREST EXPENSE -900 -900 -900 -900 -900
REPAY PRINCIPAL -10,000
INTEREST TAX SHIELD 585 585 585 585 585
DEPREC TAX SHIELD 560 560 560 560 560
NATCF W/OUT RESIDUAL 0 245 245 245 245 -9,755
PV OF NATCF 5.85% -6,489
RESIDUAL VALUE 0 0 0 0 2,000
A-T DISCOUNT RATES 8.0% 12.0% 16.0% 20.0%
PV OF RESIDUAL 1,361 1,135 952 804
PV BORROW TO BUY -5,128 -5,355 -5,537 -5,686
LEASE ANALYSIS
LEASE PAYMENT -2,500 -2,500 -2,500 -2,500 -2,500
TAX SAVINGS 875 875 875 875 875
NATCF -1,625 -1,625 -1,625 -1,625 -1,625
PV OF LEASING 5.85% -6,873
SUMMARY OF RESULTS
DISCOUNT RATES FOR RESIDUAL 8.0% 12.0% 16.0% 20.0%
PV BORROW TO BUY -5,128 -5,355 -5,537 -5,686
PV OF LEASING -6,873 -6,873 -6,873 -6,873
ADVANTAGE TO LEASE -1,745 -1,519 -1,336 -1,187

124
payments and loan payments. Therefore, the 7.6% discount rate, while it is appropriate for
the contractual flows that are unlikely to vary up or down, the residual flow may easily be
higher or lower than 2,000 euro. To take this variability into account, the analysis discounts
the residual flow at various discount rates, shown in cells B25.E27. As the discount rate
rises, the PV of the residual falls, from 1,361 to 804. At all discount rates from 8% and 12%,
the buy alternative is cheaper, although the advantage shrinks as the discount rate on the
residual rises, as shown in the summary figures on row 40, where the advantage to the
lease is always a negative number.

The decision about leasing or borrowing rests on whether the residual value is best owned
by Universal Industries or the leasing agent. Because the external financing decision was
leaning in the direction of equity financing, even under the adverse circumstances of an
undervalued share price, financial managers decided to lease the equipment and forego
any gain on the residual value five years down the road.

Leasing and Debt Capacity

The vendor of the machine told Universal Industries that leasing would conserve its cash
and borrowing capacity, as stated above. Unfortunately, that statement is not valid. You
already know from the balance sheet format used in this book, that leases are listed as
liabilities just the same as loans. See rows 69 and 76 on the LONG-FORM FORECAST
MODEL (LFFM) to refresh your memory. Therefore, leasing and borrowing should be
considered as close equivalents. The full burden coverage ratio in Chapter 2, on row 107 of
the LFFM template, includes lease expense as well as interest expense in calculating the
coverage ratio. To do anything else would be understating the fixed financial costs of the
business. A lease is a financial cost in much the same way that interest on a loan is a
financial cost.