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CHAPTER SEVEN
Viewing the Business Through the Financial Statements
Concept Questions
C7.1 Free cash flow is a dividend from the operating activities to the financing activities;
that is, it is the net cash payoff from operations that is disposed of in the financing
activities. The operations generate value then distribute some of the value in the
free cash flow dividend, leaving the remainder of the value generated reinvested in
net operating assets.
Think of a firm without any debt; in this case, C I = d, that is, the free cash flow
is the dividend to shareholders.
C7.2
Refer to the cash conservation equation: the firm must buy debt, by buying down
C7.3
The firm borrows: C - I = d + F. So, if C - I = 0, then the firm borrows to pay the
C7.4
7-1
C7.5
C7.6
C7.7
through operating earnings, and free cash flow is the residual after some of this value is
reinvested in net operating assets.
C7.8
Free cash flow (driven by operations) drives dividends. But dividends are the
residual of free cash flow after servicing the interest and principal claims of debt or
investing in net financial assets.
C7.9
Net operating assets are increased by earnings from operations and reduced by
free cash flow. Expanding, net operating assets are increased by operating revenues and
cash investment and reduced by operating expenses and cash from operations.
7-2
C7.10 Net financial obligations are increased by the obligation to pay interest, and by
dividends, and are reduced by free cash flow.
C7.11 True. Free cash flow is a dividend from the net operating assets to the net
financial obligations. So, as CSE = NOA - NFO, free cash flow does not affect CSE.
Exercises
Drill Exercises
E7.1. Applying the Cash Conservation Equation (Easy)
a. Apply the cash conservation:
CI=d+F
$143 = $49 + ?
? = $94 million
b. Net dividend (d) = $162 + 53 = $215
Debt financing flows (F) = -$86
Now apply the cash conservation equation:
CI=d+F
= $215 + (-86)
= $129 million
E7.2. Applying the Treasurers Rule
a. The treasurers rule:
C I i d = Cash applied to debt trading
$2,348 23 (14 + 54) = $2,365 million
7-3
After paying interest and receiving $40 million (14 54) from the negative net
dividend, there was $2,365 of cash left over from the free cash flow. The treasurer
used it to buy debt, either by buying back the firms own debt or investing in debt
assets.
b. From the treasurers rule,
C I i = d + cash from trading in debt
-$1,857 32 = d + cash from trading in debt
= ($1,050 + stock repurchases share issues) + cash from trading
in debt
(The dividend is $1.25 per share 840 million shares = $1,050 million)
The cash shortfall after paying the dividend is $1,857 + 32 + 1,050 = $2,939
million. The treasurer meets this shortfall by selling debt either issuing the
firms own debt or selling debt assets (financial assets) that the firm holds or
by issuing shares.
E7.3. Balance Sheet and Income Statement Relations
a. Net financial assets = Financial obligations financial assets
= $432 - $1,891
= -$1,459 million
That is, the firm has net financial obligation (negative NFA)
Net operating assets = Common equity + Net financial obligations
= $597 + 1,459
= $2,056 million
b. Operating income (after tax) = Comprehensive income + NFE (after tax)
= $108 + 47
= $155 million
E7.4. Using Accounting Relations
The reformulated balance sheet:
Net Operating Assets
2009
7-4
2009
2008
Operating assets
Operating liabilities
205.3
40.6
NOA
164.7
(a) Dividends
120.4
45.7
74.7
90.0
164.7
(Clean-surplus equation)
= 1.9
(These are net dividends)
(b) C I
= OI NOA
= 21.7 9.0
= 12.7
(c) RNOAt
(d) NBC
94
7-5
120.4
42.0
78.4
77.3
155.7
28,631
7,194
Jun-09 Dec
30,024
8,747
Financial obligations
Financial assets
Net financial obligations
Common equity
21,437
21,277
7,424
4,457
2,967
6,971
4,238
2,733
18,470
21,437
18,544
21,277
J = 690
[C - I = OI - NOA]
Cash investment:
I = (106)
(a liquidation)
[I = C - (C - I)]
M = 690
[C - I = d + F]
Net dividends:
K = 865
L = (175)
[F = d + F - d]
(more net debt issued)
(b)
7-6
2.
(c)
(d)
NFO
Operating accruals
Operating accruals
850 584
266
NOA Investment
160 (-106)
266
NFE (C - I) + d
59 690 + 865
234
850
160
690
59
631
234
865
Price
CSE (apply P/B ratio to price)
Free cash flow
Dividend (d = C - I)
2009
2008
224
140
238
119
8.4
8.4
7-7
Price + dividend
Return (246.4 224)
Rate of return
246.4
22.4
10%
(b)
There are three ways of getting the earnings:
1.
2.
3.
(12.6)
C - I + NOA
(12.6)
(Earnings
Earnings
CSE + dividend
-21 + 8.4
(12.6)
Earnings
OI
(a loss)
Applications
E7.7. Applying the Treasurers Rule: Microsoft Corporation
a.
The treasurer would run through the following calculation to find the cash surplus or
deficit:
Cash flow from operations
Cash investment
7-8
23.4 billion
3.2
20.2
0.449
20.649
40.0 billion
4.7
(2.5)
42.200
Cash surplus
(21.551)
As the surplus is actually a cash shortfall, the treasurer must sell debt. He or she does so
by selling part of the $23.7 billion in financial assets on hand.
b.
In the treasurers plan, $4.2 billion would be added to cash investments:
Cash flow from operations
Cash investment (3.2 + 4.2)
Free cash flow
Interest receipts
$702 million
Taxes
253
Cash available to shareholders
Net payout to shareholders:
Stock repurchase
Dividends
Share issued
Cash surplus
23.4 billion
7.4
16.0
0.449
16.449
40.0 billion
4.7
(2.5)
42.200
(25.751)
Now the treasurer must liquidate more of the $23.7 billion in financial assets on hand.
c.
With almost all of its financial assets of $23.7 billion distributed, under these scenarios,
Microsoft might need cash for further stock repurchases, dividends, or investments in
operations.
E7.8. Accounting Relations for Kimberly-Clark Corporation
a. Reformulate the balance sheet:
7-9
Operating assets
Operating liabilities
Net operating assets (NOA)
Financial obligations
Financial assets
$6,496.4
382.7
Common equity
2007
2008
$18,057.0
6,011.8
12,045.2
$16,796.2
5,927.2
10,869.0
6,113.7
$4,395.4
270.8 4,124.6
(ii)
$ 5,931.5
$ 6,744.4
(iii)
(i)
(blank page)
7-10