Corporate Value Creation - Karlson Lawrence C.

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Don't be concerned if it strikes you as being confusing. The purpose is to expose the reader to the terminology and nothing more. All of this will be discussed in more detail in subsequent chapters.

14

Accrued Liabilities are assumed to be included in Accounts Payable to simplify the discussion.

15

Debt due for repayment in one year or less.

16

Capital Employed can also be defined as: CE = Total Assets – Current Liabilities + Short-Term Debt.

17

An ROCE of this magnitude produced on a consistent basis would be attractive to many investors.

18

The reader can check the result of Equation [1-34] by entering the appropriate values for EBITDA, D&A, NetInt, TR, and CE from Tables 1-1 and 1-3.

19

It's important to note that when calculating the Working Capital for a company from its Balance Sheet “Cash” is included. When it comes to the Cash Flow Statements the Changes in Working Capital do not include cash because one of the objectives of the Cash Flow Statement is to show the impact that changes in Working Capital have on “Cash.”

20

Similarly, if prior and current year Accounts Receivable balances were the same, this would mean that Cash collections equaled Revenues during the year and the impact Accounts Receivable had on Cash would be neutral.

21

The discounted cash flow method (explained in detail later in this book) is one of the most widely used methods for valuing a business and considered by many to be the theoretically correct methodology.

22

Of the three financial statements, the Cash Flow Statement can be the most difficult to understand. Considerable time is spent in Chapter 10 on preparing financial statements for a company and explaining the concepts that have been covered here and subsequent chapters in more detail.

23

Table 1-6 is actually known as the “Cash Flow Proof” and usually appended to Cash Flow Statements as will be shown in Chapter 10.

24

T. E. Copeland, T. Koller, and J. Murrin, Valuation: Measuring and Managing the Value of Companies, 2nd ed. (New York: John Wiley & Sons, 1995), 166, “ROIC Tree.”

25

It can actually get a little more complicated. If the company in question has interest-bearing cash or investments, the associated interest income would give the Required Revenue some assistance and actually reduce the Revenue required to support a given level of Net Income.

26

The reader may wish to refer to the “Takeaways” section at the beginning of this chapter before proceeding to the next chapter.

27

She wasn't able to do the Cash Flow Statement for the Prior Year because data for the year before the Prior Year was not at hand.

28

The reader may notice minor discrepancies in the calculations in this chapter. When this occurs, it is the result of rounding.

29

In a leveraged buyout environment, management should and will focus on debt reduction. However, everyone involved, management and shareholders alike, will be striving to minimize the period during which they manage for cash and get to a point where they can focus on creating value through growth.

30

The basics of ROCE were covered in Chapter 1.

31

Later, expressions for Net Income and Cash Flow after Investing Activities will be developed in terms of the Investment Rate and Net Income Return on Capital Employed.

32

T. E. Copeland, T. Koller, and J. Murrin, Valuation: Measuring and Managing the Value of Companies, 2nd ed. (New York: John Wiley & Sons, 1995), 137, “What Drives Cash Flow and Value.”

33

T. Koller, R. Dobbs, and B. Huyett, The Four Cornerstones of Corporate Finance, McKinsey and Company (Hoboken, NJ: John Wiley & Sons, 2011), 237, “Appendix A.”

34

From a Cash Flow point of view, companies prefer to write off all expenses as period expenses. Tax rules can require some kinds of R&D expenditure to be capitalized. As stated elsewhere this is not a text on tax treatment and for our purposes it is assumed that all expenses except plant, equipment, and software that are utilized over multiple periods are written off (expensed) as incurred.

35

When investments in this area involve accounting and enterprise software they are usually capitalized.

36

Legal costs associated with such things as patents and acquisitions can be capitalized and amortized.

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When accounting advice involves a merger or acquisition, the costs are capitalized.

38

Like lawyers, investment bankers' fees that are associated with a transaction are capitalized.

39

One could argue that any expenditure that isn't an investment is a waste of money. In a later chapter the observation is made that “Operating Expenses” are really poorly named as such and perhaps “Operating Investments” would be more appropriate.

40

Even if the historical Investment Rate has varied considerably, a company will often assume a constant rate going forward for business planning and preparing pro-forma financial statements.

41

The material in this and the following sections is taken from Appendix D.

42

This is an important set of assumptions, especially the notion of NetInvestn providing a Net Income Return on Capital Employed of NiROCEn + 1 the following year.

43

It is important to understand the basis for this equation as well as [2-13] and [2-14]. The Net Income in Year n + 1 is the sum of the Net Income in Year n and the incremental Net Income is generated by the Net Investment made in Year n in Year n + 1. This implies that the assets that provided the Net Income in Year n will continue to provide the same level of Net Income in the subsequent years of the planning window. This is also true for the incremental Net Income provided in Year n + 1 by the Net Income Return on Capital Employed on the Net Investments made in Year n.

44

Readers who are comfortable with their grasp of the material covered so far can skip the next two sections.

45

Equations [2-20] and [2-21] both define CFaIA. The user is free to choose the one he or she prefers.

46

At this point it's worthwhile to recall the assumptions made about NI2. Specifically, the Net Income in Year 2 is the sum of the Net Income in Year 1 plus ΔNI2, which is the incremental income produced by the NiROCE2 acting on Year 1's investment.

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