Slide 1SCF BasicsSCFSCFSCFSCFSlide 7Slide 8Slide 9Slide 10Slide 11Slide 12Free Cash FlowFCFNet IncomeAccrual AccountingAccrual AccountingAccrual AccountingTax AccrualsOff Income Statement FlowsInterestTaxes For The All Equity FirmAfter Tax InterestFCFFCF from SCFFree Cash Flow to EquityFree Cash Flow to EquityReconciling with SCFFCF Challenge Question-34% taxFCF Challenge QuestionFCF Challenge QuestionFree Cash FlowCorporate Finance: MBAC 6060Professor Jaime ZenderSCF BasicsSCF is a summary of a company’s transactions for a given period that effect the cash account.It provides information about the firm’s ability to generate cash and the effectiveness of its cash management. Where is cash coming from and where is it going to?SCF is derived from the income statement for the period and (at least) the two balance sheets surrounding the period.Cash is the “life blood” of the firm so the SCF can be an important diagnostic tool and provide insight into which financial ratios should be calculated to assess the strengths and weaknesses of the firm.Cash flow information is commonly viewed as a (the) crucial piece of information for assessing the firm and its financial health by outside audiences.SCFThe generic structure of the SCF is:Cash provided (used) by operating activities.Basic running of the business, how fast cash comes in versus how fast it goes out. Tells us about how past investments are generating cash.Cash provided (used) by investing activities.Acquisition/sale of new assets.Cash provided (used) by financing activities.Raising new capital/retiring old, significant sources/uses of cash.Foreign exchange adjustments (we will largely ignore)Increase (decrease) in cash.Cash – beginning of the period.Cash – end of the period.SCFOperating Activities:Start with: Net Income (from Operations)Add: Depreciation & AmortizationSubtract: Change in non-cash oper. NWCAdd: Change in Deferred Income Tax*Total to find: Cash flow from OperationsSCFInvesting Activities:Acquisitions of fixed assets are (generally) cash outflows.Sales of fixed assets (net of any tax implications) are (generally) cash inflows.Acquisitions of (LT) financial assets are outflows.Sales/Maturities of financial assets are inflows.The net is Cash flow from Investing Activities.SCFFinancing Activities:Add the amounts of newly issued long-term or short-term debt.Subtract the amount of long-term or short-term debt retired.Subtract the amount of stock repurchases.Add the amount of new stock issues.Subtract total amount of dividends paid.Total is cash flow from financing activities.Free Cash FlowWhile the SCF is a good diagnostic tool, it does not present information in a form useful for valuation purposes. Valuation does not focus on the change in the cash account as is done on the SCF. Cash on hand is really just another asset.Recall our basic valuation equation. We need forecasts of all future cash flow expected to be generated from currently owning a firm or an asset more generally. So we introduce Free Cash Flow (FCF).The cash flow that would be generated by a firm and be available to be dispersed to its existing claimants if the firm were all equity financed.The cash flow of a company measured after it has collected its revenues, paid it expenses, and makes all investments (LT & ST) necessary to implement it’s business strategy – if it were entirely equity financed.It is important to note that free cash flow is an enterprise level concept. In practice, we use it (in combination with an appropriate discount rate) to value a firm or asset.FCFThe most theoretically correct cash flow figure to use in DCF valuation is (some variant of) Free Cash Flow.FCF:Start with: Net Income (from Operations)Add back: Depreciation & AmortizationSubtract: Change in non-cash oper. NWCSubtract: Change in required cashAdd: Change in deferred income taxSubtract: Net Capital ExpendituresAdd: After tax interest = (1-Tc)Interest Exp.Note: this is really free cash flow from operations, we are ignoring any non-operating cash flows not contained in Net Cap Ex.Net IncomeNet income is a reasonable place to start. It measures, in an accounting sense, what the existing assets are generating.Net income, however, is not a measure of any kind of cash flow (it is specifically designed not to be), so clearly we need to make adjustments.Accrual accounting.Off income statement expenditures.Interest.Accrual AccountingThe most obvious problem with using net income to capture cash flow is that non-cash expenses have been deducted and non-cash revenue has been included.The largest (commonly) is depreciation (in the past, amortization of goodwill).In order to help turn net income into free cash flow we have to add (subtract) such expenses (revenues) back into (from) net income.Accrual AccountingRevenue is booked when sales are made. This is true regardless of whether the sale is for cash or credit (i.e. whether the cash came in or not).To find cash flow we want to reflect any (and only) sales that actually generated cash (obvious).We could count only cash sales but what would that miss?It’s the timing of credit sales that are the problem.We correct by subtracting (why subtract?) the change in accounts receivable.Accrual AccountingExpenses work similarly.Expenses are booked even if we only record an accounts payable rather than an actual cash outflow.We correct by adding the change in accounts payable.The shortcut we use to deal with lots of these corrections at once is to subt ract the change in non-cash operating NWC**. Why do we subtract this change?Tax AccrualsCommonly, there are three tax accrual accounts that tell us the difference between “allowance for income taxes” (public books) and actual cash taxes paid (tax books).Prepaid taxes is a short term asset account, taxes payable is a short term liability, and deferred taxes is a long term liability (occasionally you see a 4th, deferred tax assets).We can change “book” taxes to “cash” taxes by adding the change in the asset account(s) and subtracting the changes in the liability accounts to “allowance for income taxes.”However, commonly taxes paid is not the goal, rather it is free cash flow. The two short term accounts are dealt with via the change in NWC so we only have to add the change in deferred taxes to net income to finish with tax