Fin Man 1, Chapter 3 Lecture Hand-outs

Free Cash Flow Business Analysis

A group of investors is considering buying the Wheelwright Corporation, but does not want to
contribute to the companys financial support after the purchase. Wheelwrights management
has offered the following financial statements covering last year ($M omitted):
Income Statement

Balance Sheets
Beginning

Ending

ASSETS
Sales

100

Cash

COGS*

34

Depreciation
6
Gross Margin

60

Expenses
25
EBIT
35
Interest
7
EBT
28
Tax
8
Net Income
20
*Cost of Goods Sold

6
Accts Receivable

Inventory

9
13

12
Current Assets

Fixed Assets
Gross
Accum Deprec
Net Fixed Assets
Total Assets

20
7
31

100
(12)
88

115
(18)
97

119

133

36

LIABILITIES & EQUITY

Accts Payable
Accruals
Current Liabilities
Debt
Equity
Total Liabilities
& Equity

17

21

6
23
71
25

8
29
59
45

119

133

Wheelwright paid no dividends and sold no new stock during the year. The firms tax rate is
30%.
REQUIRED: a. Develop Wheelwrights free cash flow and make a recommendation as to
whether it seems to be an appropriate acquisition for the investors.
b. Assume that the investors will purchase the company subject to its existing
debt ($59M). Does that change your recommendation?
SOLUTION:
a. First calculate Wheelwrights net operating profit and operating cash flow
NOPAT = EBIT(1-T) = $35 (1-.3) = $24.5
and
Operating Cash Flow = NOPAT + Depreciation = $24.5 + $6 = $30.5
Then subtract increases in gross fixed assets and current accounts for free cash flow,

Prepared by: Luzz B. Landicho, CPA, MBA

Faculty, College of Accountancy & Economics, PLM
Page 1 of 5

Fin Man 1, Chapter 3 Lecture Hand-outs

FCF = Operating Cash Flow Increase in Fixed Assets - Increase in Current

Accounts
= $30.5 - $15 - $1 = $14.5
Since free cash flow is substantially positive and the potential buyers are not interested in
further investment, it seems that Wheelwright is an appropriate acquisition candidate.
b. Consideration of servicing Wheelwrights debt leads to a concept known as free cash
flow to equity (FCFE). This is what remains for stockholders after the firm uses cash to pay
interest and make any payments required to reduce principal. Since interest is deductible, we
can consider its cash flow implications after tax by multiplying by (1-T).
Interest after tax = Interest (1-T) = $7 (1-.3) = $4.9
Subtracting that from free cash flow implies that Wheelwright generates almost $10M per
year thats available to pay off debt and/or distribute to shareholders. Unless the debt
requires unusually large principal payments in the short run, the firm still appears to meet the
investors requirements

Common Size Statements

Linden Corp. has a 10% market share in its industry. Below are income statements ($M) for Linden and for the
industry.
Linden
Industry
Sales
$6,000
$64,000
Cost of Goods Sold
3,200
33,650
Gross Margin
2,800
30,350
Expenses:
Sales and Marketing
430
3,850
Engineering
225
2,650
Finance and Administration
650
4,560
Total Expenses
1,305
11,060
EBIT
Interest Expense
EBT
Tax
Net Income

1,495
230
1,265
500
765

19,290
4,500
14,790
5,620
9,170

REQUIRED:

Develop common sized income statements for Linden and the industry as a whole.
SOLUTION:
Sales
Cost of Goods Sold
Gross Margin
Expenses:
Sales and Marketing
Engineering
Finance and Administration
Total Expenses

Linden
$6,000
3,200
2,800

%
100.0
53.3
47.7

Industry
$64,000
33,650
30,350

%
100.0
52.6
47.4

430
225
650
1,305

7.2
3.8
10.8
21.8

3,850
2,650
4,560
11,060

6.0
4.1
7.1
17.2

Prepared by: Luzz B. Landicho, CPA, MBA

Faculty, College of Accountancy & Economics, PLM
Page 2 of 5

Fin Man 1, Chapter 3 Lecture Hand-outs

EBIT
Interest Expense
EBT
Tax
Net Income

1,495
230
1,265
500
765

24.9
3.8
21.1
8.3
12.8

19,290
4,500
14,790
5,620
9,170

30.1
7.0
23.1
8.8
14.3

RATIO ANALYSIS
Axtel Company has the following financial statements:

In addition, Axtel retired stock for $1,000,000 and paid a dividend of $1,727,000. Depreciation for the
year was $1,166,000. Construct a Statement of Cash Flows for Axtel for 2001. (Hint: Retiring stock means buying it
back from shareholders. Assume the purchase was made at book value, and treat it like a negative sale of stock.)
REQUIRED:

Calculate all of the ratios discussed in the chapter for the Axtel Company of problem 5. Assume Axtel had leasing
costs of $7,267 in 20X1, and had 1,268,000 shares of stock outstanding that were valued at $28.75 per share at year
end.
SOLUTION:
Prepared by: Luzz B. Landicho, CPA, MBA
Faculty, College of Accountancy & Economics, PLM
Page 3 of 5

Fin Man 1, Chapter 3 Lecture Hand-outs

Current Ratio
Current Assets / Current Liabilities

= $11,678 / $2,110 = 5.5

Quick Ratio
[Current Assets Inventory] / Current Liabilities= ($11,678 $3,220) / $2,110
= 4.0
Average Collection Period (ACP)
[Accts Rec / Sales] 360

= [($5,583 / $36,227) 360]

= 55.5 days

Inventory Turnover
COGS / Inventory

= $19,925 / $3,220 = 6.2

OR

Sales / Inventory

= $36,227 / $3,220 = 11.3

Fixed Asset Turnover

Sales / Fixed Assets

= $36,227 / $11,047 = 3.3

Total Asset Turnover

Sales / Total Assets = $36,227 / $22,725 = 1.6
Debt Ratio
[Long Term Debt + Current Liabilities] / Total Assets
= ($6,002 + $2,110) / $22,725
= 35.7%
Debt to Equity Ratio
Long Term Debt: Equity

= $6,002 : $14,613
= .41:1

Times Interest Earned (TIE)

EBIT / Interest = $5,434 / $713 = 7.6
Cash Coverage
[EBIT + Depreciation] / Interest = ($5,434 + $1,166) / $713 = 9.3
Fixed Charge Coverage
[EBIT + Lease Payments] / [Interest + Lease Payments] = ($5,434 + $7,267) / ($713 + $7,267)
= 1.6
Return on Sales
Prepared by: Luzz B. Landicho, CPA, MBA
Faculty, College of Accountancy & Economics, PLM
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Fin Man 1, Chapter 3 Lecture Hand-outs

Net Income / Sales = $3,116 / $36,227 = 8.6%

Return on Assets
Net Income / Total Assets = $3,116 / $22,725 = 13.7%
Return on Equity
Net Income / Equity = $3,116 / $14,613 = 21.3%
Price Earnings Ratio (P/E)
First calculate the Earnings per Share (EPS)
EPS

= Net Income / # shares outstanding

= $3,116 / 1.268 million
= $2.46

Then
P/E

= Stock Price / EPS = $28.75 / $2.46 = 11.7

Market to Book Value Ratio

First calculate the Book Value per Share
BV per Share = Equity / # shares outstanding
= $14,613 / 1.268 million
= $11.52
Then
Market to Book Value

= Stock Price / BV per share

= $28.75 / $11.52
= 2.5

Prepared by: Luzz B. Landicho, CPA, MBA

Faculty, College of Accountancy & Economics, PLM
Page 5 of 5