Anecdote Solid Financial Analysis

EBITDA was all the rage among consultants and Wall Street for many years, because it seems both closer to cash flows than EBIT and more impervious to managerial earnings manipulation through accruals. Sadly, discounting EBITDA can be worse than discounting EBIT if capital expenditures are not netted out—and they usually are not netted out. (Forgetting about capital expenditures when depreciation is not netted out is equivalent to assuming that product falls like manna from heaven. EBIT may spread capital expenditures over time periods in a strange way, but at least it does not totally forget it!) Sometimes, a little bit of knowledge is more dangerous than no knowledge.

In June 2003, a Bear Stearns analyst valued American Italian Pasta, a small N.Y.S.E.-listed pasta maker. Unfortunately, Herb Greenberg from discovered that he forgot to subtract capital expenditures. This mistake had increased the value of American Italian Pasta from $19 to $58.49 (then trading at $43.65). Bear Stearns admitted the mistake, and came up with a new valuation, in which Bear Stern's boosted the estimate of the company's operating cash flows and dropped its estimate of the cost of capital. Presto! The NPV of this company was suddenly $68 per share. How fortunate that Bear Stearns' estimates are so robust to basic errors. Incidentally, American Italian Pasta traded at $30 in mid-2004, just above $20 by the end of 2004, and at around $10 by the end of 2005.

(In real life, accountants provide some of the numbers necessary to reconcile the differences between the unavailable tax statements and the available public statements, primarily "changes in deferred taxes." Don't worry: you will see this in Table 9.10.) Again, this simplification has helped to explain the logic. (In some countries, the financial and tax statements of public companies are identical. This raises the stakes for companies eager to manipulate their earnings.)

Finally, there are a number of other simplification, many of which are not as important for our purposes. There is a small timing difference between interest expense and when interest is actually paid. This is usually about 1 month in timing. The value impact of this difference is small, so just ignore it and use interest expense as if it were immediately paid. Moreover, Edgarscan also reported net interest income/expense of $8, which was therefore added to the table. Non-Cash Items contain M&A costs of $356 from PepsiCo's acquisition of Quaker Oats in August 2001. Note that financials are often restated, i.e., changed ex-post to reflect the acquisition of other businesses. This particular procedure is called pooling. The idea is to report financials as if the two companies had always been conjoined.

Q9.3 Show that the formulas 9.11-9.15 yield the cash flows in Table 9.7

Q9.4 Using the same cash flows as in the NPV analysis in Table 9.7, how would the project NPV change if you used a 10% cost of capital (instead of 12%) on the tax liability?

Q9.5 Rework the example (income statement, cash flow statement excerpts, cash flows, and NPV) with the following parameters.


True Lifespan Cost

Raw Output

- Input Costs

- Selling Expense = Net Output Overall Cost of Capital Corporate Tax Rate (t)

5 Years $120, year 1 $80/year $6/year $8/year $66/year 8%/year 50%

Available Financing — Executed Debt Capacity $100

Debt Interest Rate 8%/year

Accounting Treatment Accounting Life 4 Years

More minor simplifications

Solve Now!

Debt does not require interest payment in Year 1. The world is risk-neutral, because debt and project require the same expected rate of return (cost of capital).

Q9.6 For the example in the text, do both the financials and the cash flow analysis using monthly discounting. Assume that the loan is taken at year start, and most expenses and income occur pro-rata. (Warning: Time-Intensive Question. Use a computer spreadsheet. Do not do by hand!)

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