No. The ROIC of 0.5% is less than the WACC of 10%. Investors did not get the return they require.
Note: High growth usually causes negative FCF (due to investment in capital), but that’s ok if ROIC > WACC. For example, Home Depot had high growth, negative FCF, but a high ROIC.
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Chapter 7Accounting for Financial Management1Topics in ChapterIncome statementBalance sheetStatement of cash flowsAccounting income versus cash flowMVA and EVACorporate taxes2Income Statement20082009Sales$3,432,000 $5,834,400 COGS2,864,000 4,980,000 Other expenses340,000 720,000 Deprec.18,900 116,960 Tot. op. costs3,222,900 5,816,960 EBIT209,100 17,440 Int. expense62,500 176,000 EBT146,600 (158,560)Taxes (40%)58,640 (63,424)Net income$ 87,960 ($ 95,136)3What happened to sales and net income?Sales increased by over $2.4 million.Costs shot up by more than sales.Net income was negative.However, the firm received a tax refund since it paid taxes of more than $63,424 during the past two years.4Balance Sheet: Assets20082009Cash$ 9,000 $ 7,282 S-T invest.48,600 20,000 AR351,200 632,160 Inventories715,200 1,287,360 Total CA1,124,000 1,946,802 Gross FA491,000 1,202,950 Less: Depr.146,200 263,160 Net FA344,800 939,790 Total assets$1,468,800 $2,886,592 5Effect of Expansion on AssetsNet fixed assets almost tripled in size.AR and inventory almost doubled.Cash and short-term investments fell.6Statement of Retained Earnings, 2009Balance of ret. earnings, 12/31/2008$203,768 Add: Net income, 2009(95,136) Less: Dividends paid, 2009(11,000)Balance of ret. earnings, 12/31/2009$97,632 7Balance Sheet: Liabilities & Equity20082009Accts. payable$ 145,600 $ 324,000 Notes payable200,000 720,000 Accruals136,000 284,960 Total CL481,600 1,328,960 Long-term debt323,432 1,000,000 Common stock460,000 460,000 Ret. earnings203,768 97,632 Total equity663,768 557,632 Total L&E$1,468,800 $2,886,592 8What effect did the expansion have on liabilities & equity?CL increased as creditors and suppliers “financed” part of the expansion.Long-term debt increased to help finance the expansion.The company didn’t issue any stock.Retained earnings fell, due to the year’s negative net income and dividend payment.9Statement of Cash Flows: 2009Operating ActivitiesNet Income($ 95,136)Adjustments: Depreciation116,960 Change in AR(280,960) Change in inventories(572,160) Change in AP178,400 Change in accruals148,960 Net cash provided (used) by ops.($503,936)10Investing Activities Cash used to acquire FA($711,950) Change in S-T invest.28,600 Net cash prov. (used) by inv. act.($683,350)11Financing Activities Change in notes payable$ 520,000 Change in long-term debt676,568 Payment of cash dividends(11,000)Net cash provided (used) by fin. act.$1,185,56812Summary of Statement of CFNet cash provided (used) by ops.($ 503,936)Net cash to acquire FA(683,350)Net cash prov. (used) by fin. act.1,185,568Net change in cash(1,718)Cash at beginning of year9,000Cash at end of year$ 7,28213What can you conclude from the statement of cash flows?Net CF from operations = -$503,936, because of negative net income and increases in working capital.The firm spent $711,950 on FA. The firm borrowed heavily and sold some short-term investments to meet its cash requirements.Even after borrowing, the cash account fell by $1,718.14What is free cash flow (FCF)? Why is it important?FCF is the amount of cash available from operations for distribution to all investors (including stockholders and debtholders) after making the necessary investments to support operations.A company’s value depends upon the amount of FCF it can generate.15What are the five uses of FCF?1. Pay interest on debt.2. Pay back principal on debt.3. Pay dividends.4. Buy back stock.5. Buy nonoperating assets (e.g., marketable securities, investments in other companies, etc.)16What are operating current assets?Operating current assets are the CA needed to support operations.Op CA include: cash, inventory, receivables.Op CA exclude: short-term investments, because these are not a part of operations.17What are operating current liabilities?Operating current liabilities are the CL resulting as a normal part of operations.Op CL include: accounts payable and accruals.Op CL exclude: notes payable, because this is a source of financing, not a part of operations.18Net Operating Working Capital (NOWC)NOWC09 = ($7,282 + $632,160 + $1,287,360) - ($324,000 + $284,960) = $1,317,842.NOWC08 = $793,800.= -OperatingCAOperatingCLNOWC19Total net operating capital (also called operating capital)Operating Capital= NOWC + Net fixed assets.Operating Capital 2009 = $1,317,842 + $939,790 = $2,257,632.Operating Capital 2008 = $1,138,600.20Net Operating Profit after Taxes (NOPAT) NOPAT = EBIT(1 - Tax rate)NOPAT09 = $17,440(1 - 0.4) = $10,464.NOPAT08 = $125,460.21Free Cash Flow (FCF) for 2009FCF = NOPAT - Net investment in operating capital = $10,464 - ($2,257,632 - $1,138,600) = $10,464 - $1,119,032 = -$1,108,568.How do you suppose investors reacted?22Return on Invested Capital (ROIC)ROIC = NOPAT / operating capitalROIC09 = $10,464 / $2,257,632 = 0.5%.ROIC08 = 11.0%. 23The firm’s cost of capital is 10%. Did the growth add value?No. The ROIC of 0.5% is less than the WACC of 10%. Investors did not get the return they require.Note: High growth usually causes negative FCF (due to investment in capital), but that’s ok if ROIC > WACC. For example, Home Depot had high growth, negative FCF, but a high ROIC.24Economic Value Added (EVA)WACC is weighted average cost of capitalEVA = NOPAT- (WACC)(Capital)25Economic Value Added(WACC = 10% for both years)EVA = NOPAT- (WACC)(Capital)EVA09 = $10,464 - (0.1)($2,257,632) = $10,464 - $225,763 = -$215,299.EVA08 = $125,460 - (0.10)($1,138,600) = $125,460 - $113,860 = $11,600.26Stock Price and Other Data20082009Stock price$8.50$6.00# of shares100,000 100,000EPS$0.88-$0.95DPS$0.22$0.1127Market Value Added (MVA)MVA = Market Value of the Firm - Book Value of the FirmMarket Value = (# shares of stock)(price per share) + Value of debtBook Value = Total common equity + Value of debt(More)28MVA (Continued)If the market value of debt is close to the book value of debt, then MVA is:MVA = Market value of equity – book value of equity292009 MVA (Assume market value of debt = book value of debt.)Market Value of Equity 2009:(100,000)($6.00) = $600,000.Book Value of Equity 2009:$557,632.MVA09 = $600,000 - $557,632 = $42,368.MVA08 = $850,000 - $663,768 = $186,232.30Key Features of the Tax CodeCorporate TaxesIndividual Taxes312008 Corporate Tax RatesTaxable IncomeTax on BaseRate on amount above base0 -50,000015%50,000 - 75,0007,50025%75,000 - 100,00013,75034%100,000 - 335,00022,25039%335,000 - 10M113,90034%10M - 15M3,400,00035%15M - 18.3M5,150,00038%18.3M and up6,416,66735%32Features of Corporate TaxationProgressive rate up until $18.3 million taxable income.Below $18.3 million, the marginal rate is not equal to the average rate.Above $18.3 million, the marginal rate and the average rate are 35%.33Features of Corporate Taxes (Cont.)A corporation can:deduct its interest expenses but not its dividend payments;carry back losses for two years, carry forward losses for 20 years.*exclude 70% of dividend income if it owns less than 20% of the company’s stock*Losses in 2001 and 2002 can be carried back for five years.34ExampleAssume a corporation has $100,000 of taxable income from operations, $5,000 of interest income, and $10,000 of dividend income.What is its tax liability?35Operating income$100,000Interest income5,000Taxable dividendincome3,000*Taxable income$108,000*Dividends - Exclusion = $10,000 - 0.7($10,000) = $3,000.Example (Continued)36Taxable Income = $108,000Tax on base = $22,250Amount over base = $108,000 - $100,000 = $8,000Tax = $22,250 + 0.39 ($8,000) = $25,370.Example (Continued)37Key Features of Individual TaxationIndividuals face progressive tax rates, from 10% to 35%. The rate on long-term (i.e., more than one year) capital gains is 15%. But capital gains are only taxed if you sell the asset.Dividends are taxed at the same rate as capital gains.Interest on municipal (i.e., state and local government) bonds is not subject to Federal taxation.38Taxable versus Tax Exempt BondsState and local government bonds (municipals, or “munis”) are generally exempt from federal taxes.39ExxonMobil bonds at 10% versus California muni bonds at 7%T = Tax rate = 25.0%.After-tax interest income:ExxonMobil = 0.10($5,000) - 0.10($5,000)(0.25) ExxonMobil = 0.10($5,000)(0.75) = $375.CAL = 0.07($5,000) - 0 = $350.40Breakeven Tax RateAt what tax rate would you be indifferent between the muni and the corporate bonds?Solve for T in this equation:Muni yield = Corp Yield(1-T)7.00% = 10.0%(1-T)T = 30.0%.41ImplicationsIf T > 30%, buy tax exempt munis.If T < 30%, buy corporate bonds.Only high income, and hence high tax bracket, individuals should buy munis.42
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