Cash Flow Statements and Warf Computers Mini Case [PDF]

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Cash Flow Statement EMB 660: Corporate Finance Summer 2021 This chapter presents the cash flow statement from two perspectives – a finance perspective and an accounting perspective. Cash flow statement prepared from a finance perspective is named a Financial Cash Flow Statement while the one prepared from an accounting perspective is labelled an Accounting Cash Flow Statement. There are several differences between cash flow statements prepared from the two perspectives: Financial Cash Flow Statement All current assets are included in computing the net investment in net working capital (NINWC). Operating Cash Flow (OCF) is calculated as Earnings before Interest and Taxes (EBIT) plus Depreciation minus current taxes. That means the EBIT is the anchor of OCF calculation. It is used as the basis of OCF and adjusted for noncash expenses such as depreciation, and current taxes. Effectively, OCF = NOPAT + Depreciation



Note the 2 differences: one, EBIT is the anchor of calculations and two, cash and cash equivalents are included while calculating the change in net working capital. OCF formula: OCF = EBIT + Depreciation – Current taxes



Accounting Cash Flow Statement All current assets except cash and cash equivalents are included in computing the net investment in net working capital (NINWC) Operating Cash Flow (OCF) is calculated as Net Income plus all non-cash expenses, e.g., depreciation, amortization, impairments, and write-offs and all non-operating expenses and losses, e.g., loss on sale of old equipment or loss on sale of available-for-sale (AFS) securities minus all non-cash earnings, e.g., unrealized gain on appreciation in the value of trading securities and all non-operating gains such as gain on sale of land. Net income is further adjusted for working capital changes except change in cash and cash equivalents. Decreases in current assets are added and increases subtracted while decreases in current liabilities are subtracted and increases added to find OCF. Note the 2 differences between the two OCF calculations: one, the net income is the anchor of OCF calculation and two, cash and cash equivalents not included in the workings.



OCF formula: OCF = Net income + Depreciation + Deferred taxes – Net investment in net working capital Please note some important similarities and differences: 1) Instead of anchoring on EBIT, Accounting CF Statement anchors on Net Income;



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Investing Cash Flow (ICF) Investing cash flow, or ICF, represents net investment in long-term operating assets such as property, plant, and equipment (PPE), and any intangible assets. This is calculated as:



2) Like Financial CF, it adds non-cash and non-operating expenses and subtracts non-cash and non-operating revenues and gains. 3) Instead of subtracting current taxes, it adds deferred taxes (because it’s a noncash expense). 4) Finally, it subtracts net investment in net working capital here in the OCF segment. Investing Cash Flow (ICF) Same as in the Financial Cash Flow



ICF = Change in net PPE + Depreciation Change in net PPE means net PPE this year – net PPE last year. Financing Cash Flow (FCF) FCF has two components – transactions with debtholders and those with stockholders. Transactions with debtholders includes all debt service payments such as interests and loan repayments that cause cash to flow out of the firm minus borrowings such as bond issues and other forms of loans that bring in cash to the firm. Cash Flow Paid to Creditors = Interest + Debt retirement – Net proceeds from long-term debt sales, e.g., net proceeds from a bond issue.



Financing Cash Flow (FCF) The Accounting Cash Flow Statement does not split FCF between two components as the Financial CF does. Secondly, the interest expense is not included in FCF. It is dealt with in OCF as OCF anchors on Net Income, which would have subtracted interest expense already! FCF = Debt retirement – Net proceeds from longterm debt sales, e.g., net proceeds from a bond issue + Dividends Plus Stock Repurchases – Proceeds from new stock issues.



Cash Flow to Stockholders = Dividends Plus Stock Repurchases – Proceeds from new stock issues.



Another important point to remember is that all signs in ICF and FCF are alternated here. All inflows are considered positive and outflows negative. Therefore, items such as debt retirement, dividend or stock repurchase will be negative while net proceeds from a bond or a stock issue will be positive.



Preparing a Financial Cash Flow Statement can be expressed as a 4-step process:



Preparing a Financial Cash Flow Statement can be expressed as a 3-step process:



Transactions with stockholders include stock issues, dividend payments, and stock repurchases.



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Step 1: Calculate Net Investment in Net Working Capital (NINWC):



This step is partially integrated in Step 2, OCF calculation.



NINWC = Δ Net Working Capital = Net Working Capitalthis year – Net Working Capitallast year = (Current AssetsYear1 – Current Liabilitiesyear1) – (Current AssetsYear0 – Current Liabilitiesyear0) Step 2: Calculate OCF: Step 2: Calculate OCF OCF = EBIT + Depreciation – Current taxes OCF = Net Income Step 3: Capital Expenditure or ICF Alternative 1: (using change in net PPE): ICF = Δ Net PPE + Depreciation + Book Value of PPE sold (if any) + Δ Intangible Assets (if any)



+ non-cash expenses, e.g., depreciation, amortization, impairment, write-off + non-operating expenses and losses, e.g., loss on sale of old equipment or loss on sale of availablefor-sale (AFS) securities



= (Net PPEyear1 – Net PPEyear0) + Depreciation + Book Value of PPE Sold (if any) + (Intangible Assetsyear1 – Intangible Assetsyear0)



- non-cash earnings, e.g., unrealized gain on appreciation in the value of trading securities



Alternative 2: (using change in gross PPE):



- non-operating gains, e.g., gain on sale of land



ICF = Δ Gross PPE + Gross Value of PPE sold (if any) + Δ Intangible Assets (if any)



- net investment in net operating working capital e.g.,



= (Gross PPEyear1 – Gross PPEyear0) + Gross Value of PPE Sold (if any) + (Intangible Assetsyear1 – Intangible Assetsyear0)



- increase (if any) in operating current assets such as inventories, accounts receivable, supplies, prepaid expenses, etc.



Note that the only difference between the two methods is that under the Gross method, you don’t have to add depreciation.



+ decrease (if any) in the above + increase (if any) in operating current liabilities such as accounts payable, wages payable, accrued expenses, deferred taxes, etc. and - decrease (if any) in the above. Step 3: Identical to the calculation of Financial Cash Flow



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Step 4: Calculate FCF:



Step 4: Calculate FCF:



Cash Paid to Creditors = Interest + Debt retirement – Net proceeds from long-term debt sales, e.g., net proceeds from a bond issue.



No distinction is made between cash paid to creditors and stockholders. Also, interest not considered.



Cash Flow to Stockholders = Dividends Plus Stock Repurchases – Proceeds from new stock issues.



FCF =



Proof: Operating cash Flow – Investing Cash Flow – Investment in Net Working Capital = Cash paid to creditors + Cash paid to stockholders CF (A) = CF (B) + CF (S) CF (A) = OCF – ICF – NINWC CF (B) = Cash paid to creditors and CF (S) = Cash paid to stockholders Treasurer’s Rule: C–I=d+F C = OCF - NINWC I = ICF d = Cash paid to stockholders and F = Cash paid to debtholders



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– Debt retirement + Net proceeds from long-term debt sales, e.g., net proceeds from a bond issue. – Dividends – Stock Repurchases + Proceeds from new stock issues. Proof: OCF + ICF + FCF = Change in Cash and cash Equivalents.



Mini Case on Page 41 Cash Flows at Warf Computers, Inc. Financial Cash Flow Step 1: Calculate net investment in net working capital (NINWC) 2019



2018



Current Assets: $2,280 Current Liabilities 919 Working Capital: $1,361



Current Assets: $2,160 Current Liabilities 1,063 Working Capital: $1,097



Accounting Cash Flow



Working capital2019 – Working Capital2018 = $1,361 – $1,097 = $264 Step 2: Calculate OCF:



Step 2: Calculate OCF:



OCF = EBIT + Depreciation – Current Taxes = $2,665 + $298 – $559 = $2,404



OCF = Net income $1,876 + Depreciation…………298 – Increase in accounts receivable…57 + Decrease in inventories…………….26 – Increase in other current assets...16 + Increase in accounts payable…41 – Decrease in accrued expenses….185 + Increase in deferred taxes….66 = OCF……………..$2,049



Step 3: Calculate ICF or Capital Expenditure



Step 3: Calculate ICF or Capital Expenditure



ICF = Δ Net PPE + Depreciation + Δ Intangible Assets = ($3,370 – $2,505) + $298 + ($953 – $851) = $865 + $298 + $102 = $1,265



ICF = Δ Net PPE + Depreciation + Δ Intangible Assets = ($3,370 – $2,505) + $298 + ($953 – $851) = $865 + $298 + $102 = $1,265



Step 4: Calculate FCF



Step 4: Calculate FCF



Cash Flow from transactions with debtholders: = Interest + Debt retirement – Proceeds from long-term debt sales = Interest paid – net new borrowing = Interest paid – (Ending long-term debt – Beginning long-term debt)



Cash Flow from transactions with debtholders: = Debt retirement – Proceeds from long-term debt sales = net new borrowing = Ending long-term debt – Beginning long-term debt



= $164 – ($274 – $238) = $164 – $36 = $128



= ($274 – $238) = $36



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Cash Flow from transactions with stockholders: = Dividend paid – New issue raised = Dividend paid – (Stock sold – Stock repurchased) = $688 – ($4 + $15 – $79) = $688 + $60 = $748



Cash Flow from transactions with stockholders: = Dividend paid – New issue raised = Dividend paid – (Stock sold – Stock repurchased) = $688 – ($4 + $15 – $79) = $688 + $60 = $748



Proof:



Proof:



OCF – ICF – NINWC = CF (Debtholders) + CF (Stockholders)



OCF + ICF + FCF = Δ Cash and cash equivalents



Or, CF (A) = CF (B) + CF (S) Or, $2404 – $1,265 – $264 = $128 + $748 Or, $875 = $876 (almost )



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$2,049 + ($1,265) + $36 + ($748) = $542 – $469 Or, $72 = $73 (almost!)