Valuation Cash FlowA Teaching NoteCash Flow from Accounting NumbersUnfortunately the most valuable and reliable information about a firm=s cash flows is not often presented in the form of annual net cash flows to the firm. It comes in the form of income statements, balance sheets, and statements of cash flow. Here is a quick and somewhat rough explanation of how to get to where we need to be. We will consider the development of two separate Afinancial cash flow@ figures, Capital Cash Flow (CCF) and Free Cash Flow (FCF).CCF is defined to be the after tax cash flow that is available to be returned to the contributors of capital (all security holders) after all valuable investments have been made. FCF is the after tax cash flow that would be available to be distributed after making all valuable investments if the firmwere an all equity financed firm (i.e., not including any increase in cash derived from the use of debt financing). While FCF is a hypothetical value it is theoretically more correct to use it in valuation. We can develop both values in several ways. The easiest and most accurate is to start from net income. This uses the firm=s forecast of taxes and the value of the tax shields. This is usually better than our estimates of taxes would be.Net income (net earnings) includes any tax benefit from debt financing (debt tax shields) since interest is deducted before computing taxes. We will have to deal with this.Cash flow adjustments are made to NI. Depreciation, Amortization, and other noncash subtractions from NI are added back to it. Capital Expenditures are subtracted because these cash outflows do not appear on the income statement and so have not been subtracted from NI. Cap Ex is expenditures on new and replacement PP&E, essentially the increase in net fixed assets plus depreciation expense. Technically this is Gross Cap Ex less the net book value of retired assets, but this is typically small. (Some instead use the increase in gross fixed assets, either works for forecasting purposes.) We subtract changes in Net Working Capital1 to convert recognized accounting revenues and costs into cash revenues and costs. Another accrual/cash flow adjustment that must be done is to account for the difference between cash taxes and the “allowance for income taxes” reported on the public statements. It is fairly common for there to be four tax accrual accounts; deferred income tax, a long-term liability account, deferred tax assets, a long-term asset, taxes payable, a current liability account, and prepaid income taxes, a current asset. We can do the tax adjustment separately and adjust NI for the difference between taxes paid and the tax expense. However note that if we subtract the change in NWC from NI we1 This isn’t quite true. In actuality we have to worry about two subtle points. First increases in the cash account above the minimum desired balance (since cash is usually used as a residual account) should not be included in the changes in NWC. Second, the current portion of long term debt should be excluded from NWC for this purpose. The reasoning is as follows. Increases in the cash account up to the minimum desired balance is an investment in a necessary asset (liquidity) and so this is not available to be paid out to claimants, however, increases in the cash account above this desired balance could be paid out to claimants without hampering the ability of the firm to operate effectively. We want this included in FCF for this reason. Changes in the current portion of long term debtis the result of financing decisions and as such should not affect FCF anymore than the issuance of new debt or equity or the payment of a dividend.automatically adjust for the two current accounts and all we have left to do is to add the change (because it is a liability and increases in a liability are a source of cash) in deferred income taxes and subtract the change in deferred tax assets as further cash flow adjustments.NI is net of noncash interest (if there is any) and since this is not a cash outflow it is added back. At this point we have something often called Aavailable cash flow@, a standard item on many projection exercises. It measures the funds available for debt repayment or other uses.To available cash flow we add cash interest (which was subtracted from NI) and we arrive at CCF,the cash flow actually generated that is available for payment to all security holders. Since the interest tax shields are included in the cash flows, and the cash flows are those available to all security holders, a before-tax discount rate that corresponds to the riskiness of the assets is appropriate to value these cash flows. Note that from here if we simply subtract the benefits of debt financing (the debt tax shields, the corporations tax rate, Tc, times interest) we find FCF.In Shorthand:NICash Flow AdjustmentsAdd Non-Cash InterestGives AAvailable Cash Flow@Add Cash InterestTo Find Capital Cash FlowSubtract Interest Tax ShieldTo Find Free Cash FlowAlternatively, to available cash flow we add after tax interest, (1-Tc)Interest, to find FCF.If we start with EBIT we must make some estimates of taxes and the tax benefits of debt financing. Taxes are usually estimated by multiplying a historical tax rate (think about how appropriate this is if we are doing a recapitalization) times EBIT. EBIAT = (1-TC)EBIT.EBIAT is then adjusted using the cash flow adjustments. EBIAT plus the cash flow adjustments equals Free Cash Flow, the cash flow to an all equity firm. FCF can be valued using either the WACC or the APV methods (see below). Since FCF doesn=t include the benefits of debt financing, we add an estimate of the annual interest tax shield to the FCF to find CCF.In shorthand:EBITless TC (EBIT)is (1-TC)EBIT = EBIATuse the Cash flow Adjustmentsgives FCFadd Interest Tax Shieldgives CCFKnow why these are the same!Valuation ExerciseHere is a valuation exercise you will be able to complete by the end of this course. For now, you should attempt to develop free cash flow and capital cash flow projections for the years 1995, 1996, and 1997 so you can see the first step of this kind of analysis. Toward the end of the class, come back and finish the job.Consider the case of the very hypothetical company, X Inc. Ultimately the issue will be for you tocome up with several value estimates (WACC, APV, and CCF anacronyms that look mysterious now but won’t later) for the