Download Net Capital Expenditures

Valuation
FIN449
Michael Dimond
DISTORTIONS
Michael Dimond
School of Business Administration
Expected FCF
• Forecast, then Recast
– Start by predicting what is likely to be published on the financial
statements.
– After that, recast the figures to better reflect the economic realities for
operating leases, R&D (if applicable) and sustainability of operating
cash flows.
• Compute FCFs using more than one formula to ensure you
have found all the issues in your figures.
Michael Dimond
School of Business Administration
Updating Earnings
• When valuing companies, we often depend upon financial
statements for inputs on earnings and assets. Annual reports
are often outdated and can be updated by using– Trailing 12-month data, constructed from quarterly earnings reports.
– Informal and unofficial news reports, if quarterly reports are
unavailable.
• Updating makes the most difference for smaller and more
volatile firms, as well as for firms that have undergone
significant restructuring.
Michael Dimond
School of Business Administration
One-Time and Non-recurring Charges
• Assume that you are valuing a firm that is reporting a loss of
$ 500 million, due to a one-time charge of $ 1 billion. What is
the earnings you would use in your valuation?
 A loss of $ 500 million
 A profit of $ 500 million
Would your answer be any different if the firm had reported onetime losses like these once every five years?
 Yes
 No
Michael Dimond
School of Business Administration
Correcting Accounting Earnings
• The Operating Lease Adjustment: While accounting
convention treats operating leases as operating expenses,
they are really financial expenses and need to be reclassified
as such. This has no effect on equity earnings but does
change the operating earnings
• COGS Adjustment: Inventory costs are associated with
particular goods using one of several formulas, including
specific identification, last-in first-out (LIFO), first-in first-out
(FIFO), or average cost. This may affect the value of a firm
compared to the accounting information presented.
• The R & D Adjustment: Since R&D may create value for
multiple years, operating income can be adjusted (only if
there is significant intellectual property).
Michael Dimond
School of Business Administration
Dealing with Operating Lease Expenses
• Operating Lease Expenses are treated as operating
expenses in computing operating income. In reality,
operating lease expenses should be treated as
financing expenses, with the following adjustments to
earnings and capital:
• Debt Value of Operating Leases = PV of Operating
Lease Expenses at the pre-tax cost of debt
• Adjusted Operating Earnings
Adjusted Operating Earnings = Operating Earnings + Operating
Lease Expenses - Depreciation on Leased Asset
– As an approximation, this works:
Adjusted Operating Earnings = Operating Earnings + Pre-tax cost
of Debt * PV of Operating Leases.
Michael Dimond
School of Business Administration
Effects of Capitalizing Operating Leases
• Debt : will increase, leading to an increase in debt
ratios used in the cost of capital and levered beta
calculation
• Operating income: will increase, since operating
leases will now be before the imputed interest on the
operating lease expense
• Net income: will be unaffected since it is after both
operating and financial expenses anyway
• Return on Capital will generally decrease since the
increase in operating income will be proportionately
lower than the increase in book capital invested
Michael Dimond
School of Business Administration
The Magnitude of Operating Leases
Operating Lease expenses as % of Operating Income
60.00%
50.00%
40.00%
30.00%
20.00%
10.00%
0.0 0%
Marke t
App arel Stores
Furn iture Store s
Resta urants
Michael Dimond
School of Business Administration
Dealing with Operating Leases
• In 1998, Home Depot did not carry much in terms of
traditional debt on its balance sheet. However, it did have
significant operating leases.
• When doing firm valuation, these operating leases have to be
treated as debt. This, in turn, will mean that operating income
has to get restated.
Michael Dimond
School of Business Administration
Operating Leases at Home Depot in 1998
• The pre-tax cost of debt at the Home Depot is 5.80%
Year
Commitment
Present Value
1
$294.00
$277.88
2
$291.00
$259.97
3
$264.00
$222.92
4
$245.00
$195.53
5
$236.00
$178.03
6 and beyond $2700.00
$1,513.37
• Debt Value of leases =
$2,647.70
Michael Dimond
School of Business Administration
Operating Leases at Home Depot in 1998
• The pre-tax cost of debt at the Home Depot is 5.80%
Year
Commitment
Present Value
1
$294.00
$277.88
2
$291.00
$259.97
3
$264.00 Average = 266 $222.92
4
$245.00
$195.53
5
$236.00
$178.03
6 and beyond $2700.00
$1,513.37
PV of 270/yr for 10 yrs
2700 / 266 =~10 yrs
2700 / 10 = 270/yr for years 6-15
• Debt Value of leases =
$2,647.70
Michael Dimond
School of Business Administration
Operating Leases at Home Depot in 1998
kd
Year
5.80%
Commitment
1
294
2
291
3
264
4
245
5
236
6 & Beyond
2700
Commitment
294
291
264
245
236
266 10.15038
270
270
270
270
270
270
270
270
270
270
Year
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
PV
277.8828
259.9691
222.9189
195.5345
178.0261
192.5084
181.955
171.9802
162.5522
153.641
145.2183
137.2574
129.7329
122.6209
115.8987
Michael Dimond
School of Business Administration
Other Adjustments from Op. Leases
EBIT
EBIT (1-t)
Debt
Operating Lease
Expensed
$ 2,661mil
$1,730 mil
$1,433 mil
Operating Lease
converted to Debt
$ 2,815 mil
$1,829 mil
$ 4,081 mil
• What else?
Michael Dimond
School of Business Administration
Inventory Methods: LIFO vs FIFO
• (a) First-in, First-out (FIFO): Under FIFO, the cost of goods sold is based
upon the cost of material bought earliest in the period, while the cost of
inventory is based upon the cost of material bought later in the year. This
results in inventory being valued close to current replacement cost.
• (b) Last-in, First-out (LIFO): Under LIFO, the cost of goods sold is based
upon the cost of material bought towards the end of the period, resulting
in costs that closely approximate current costs. The inventory, however, is
valued on the basis of the cost of materials bought earlier in the year.
• A switch from LIFO to FIFO in valuing inventory will likely cause a rise in
net income and a decrease in cash flows (because of the tax effect).
• Firms that choose to use the LIFO approach to value inventories have to
specify in a footnote the difference in inventory valuation between FIFO
and LIFO, and this difference is termed the LIFO reserve. This can be
used to adjust the beginning and ending inventories, and consequently
the cost of goods sold, and to restate income based upon FIFO valuation.
Michael Dimond
School of Business Administration
Capitalizing R&D Expenses
• Accounting standards require us to consider R&D as
an operating expense even though it is designed to
generate future growth. In some firms, it is more
logical to treat it as capital expenditures.
• To capitalize R&D,
– Specify an amortizable life for R&D (2 - 10 years)
– Collect past R&D expenses for as long as the amortizable life
– Sum up the unamortized R&D over the period. (Thus, if the
amortizable life is 5 years, the research asset can be obtained
by adding up 1/5th of the R&D expense from five years ago,
2/5th of the R&D expense from four years ago...:
Michael Dimond
School of Business Administration
The Magnitude of R&D Expenses
R&D as % of Operating Income
60.00%
50.00%
40.00%
30.00%
20.00%
10.00%
0.0 0%
Marke t
Petro leum
Compu ters
Michael Dimond
School of Business Administration
Capitalizing R&D Expenses: Cisco
• R & D was assumed to have a 5-year life.
(all figures as of 1999 data)
Year
R&D Expense
Unamortized portion
Amortization this year
1999
1594.00
1.00
1594.00
1998
1026.00
0.80
820.80
$205.20
1997
698.00
0.60
418.80
$139.60
1996
399.00
0.40
159.60
$79.80
1995
211.00
0.20
42.20
$42.20
1994
89.00
0.00
0.00
$17.80
Total
$ 3,035.40
$ 484.60
Value of research asset =
$ 3,035.4 million
Amortization of research asset in 1998 =
$ 484.6 million
Adjustment to Operating Income = $ 1,594 million - 484.6 million = 1,109.4 million
Michael Dimond
School of Business Administration
The Effect of Capitalizing R&D
• Operating Income will generally increase, though it depends
upon whether R&D is growing or not. If it is flat, there will be no
effect since the amortization will offset the R&D added back.
The faster R&D is growing the more operating income will be
affected.
• Net income will increase proportionately, depending again upon
how fast R&D is growing
• Book value of equity (and capital) will increase by the
capitalized Research asset
• Capital expenditures will increase by the amount of R&D;
Depreciation will increase by the amortization of the research
asset; For all firms, the net cap ex will increase by the same
amount as the after-tax operating income.
Michael Dimond
School of Business Administration
Net Capital Expenditures
• Net capital expenditures represent the difference
between capital expenditures and depreciation.
Depreciation is a cash inflow that pays for some or a
lot (or sometimes all of) the capital expenditures.
• In general, the net capital expenditures will be a
function of how fast a firm is growing or expecting to
grow. High growth firms will have much higher net
capital expenditures than low growth firms.
• Assumptions about net capital expenditures can
therefore never be made independently of
assumptions about growth in the future.
Michael Dimond
School of Business Administration
Capital expenditures should include
• Research and development expenses, once they have
been re-categorized as capital expenses. The
adjusted net cap ex will be
Adjusted Net Capital Expenditures = Net Capital Expenditures +
Current year’s R&D expenses - Amortization of Research Asset
• Acquisitions of other firms, since these are like capital
expenditures. The adjusted net cap ex will be
Adjusted Net Cap Ex = Net Capital Expenditures + Acquisitions of
other firms - Amortization of such acquisitions
Two caveats:
1. Most firms do not do acquisitions every year. Hence, a
normalized measure of acquisitions (looking at an average over
time) should be used
2. The best place to find acquisitions is in the statement of cash
flows, usually categorized under other investment activities
Michael Dimond
School of Business Administration
Cisco’s Acquisitions: 1999
Acquired
GeoTel
Fibex
Sentient
American Internet
Summa Four
Clarity Wireless
Selsius Systems
PipeLinks
Amteva Tech
Method of Acquisition
Pooling
Pooling
Pooling
Purchase
Purchase
Purchase
Purchase
Purchase
Purchase
Price Paid
$1,344
$318
$103
$58
$129
$153
$134
$118
$159
$2,516
Michael Dimond
School of Business Administration
Cisco’s Net Capital Expenditures in 1999
Cap Expenditures (from statement of CF)
- Depreciation (from statement of CF)
Net Cap Ex (from statement of CF)
+ R & D expense
- Amortization of R&D
+ Acquisitions
Adjusted Net Capital Expenditures
= $ 584 mil
= $ 486 mil
= $ 98 mil
= $ 1,594 mil
= $ 485 mil
= $ 2,516 mil
= $3,723 mil
(Amortization was included in the depreciation number)
Michael Dimond
School of Business Administration