Session 7: Estimating cash flows

1. Aswath Damodaran Session 7: Estimating cash flows

2. Cash Flows Aswath Damodaran

3. Steps in Cash Flow Estimation • Estimate the current earnings of the firm • If cash flows to equity, look at net income • If cash flows to the firm, look at operating earnings after taxes • Consider how much the firm invested to create future growth. • If looking at cash flows to equity, consider the cash flows from net debt issues (debt issued - debt repaid) Aswath Damodaran

4. Defining Cashflow

5. From Reported to Actual Earnings

6. Dealing with Operating Lease Expenses • Operating Lease Expenses are financial expenses, not operating expenses • Debt Value of Operating Leases = Present value of Operating Lease Commitments at the pre-tax cost of debt • Adjusted Operating Earnings • Adjusted Operating Earnings = Operating Earnings + Operating Lease Expenses - Depreciation on Leased Asset

7. Operating Leases at Amgen in 2007 • Amgen has lease commitments and its cost of debt (based on it’s A rating) is 5.63%. Year Commitment Present Value 1 $96.00 $90.88 2 $95.00 $85.14 3 $102.00 $86.54 4 $98.00 $78.72 5 $87.00 $66.16 6-12 $107.43 $462.10 ($752 million prorated) • Debt Value of leases = $869.55 • Debt outstanding at Amgen = $7,402 + $ 870 = $8,272 million • Adjusted Operating Income = Stated OI + Lease expense this year – Depreciation = 5,071 m + 69 m - 870/12 = $5,068 million (12 year life for assets)

8. R&D Expenses: Operating or Capital Expenses • R&D is a capital expense, not an operating expense. • To capitalize R&D, • Specify an amortizable life for R&D (2 - 10 years) • Collect past R&D expenses for the amortizable life • Sum up the unamortized R&D over the period.

9. Capitalizing R&D Expenses: Amgen • R & D was assumed to have a 10-year life. Year R&D Expense Unamortized portion Amortization this year Current 3366.00 1.00 3366.00 -1 2314.00 0.90 2082.60 $231.40 -2 2028.00 0.80 1622.40 $202.80 -3 1655.00 0.70 1158.50 $165.50 -4 1117.00 0.60 670.20 $111.70 -5 865.00 0.50 432.50 $86.50 -6 845.00 0.40 338.00 $84.50 -7 823.00 0.30 246.90 $82.30 -8 663.00 0.20 132.60 $66.30 -9 631.00 0.10 63.10 $63.10 -10 558.00 0.00 $55.80 Value of Research Asset = $10,112.80 $1,149.90 • Adjusted Operating Income = $5,120 + 3,366 - 1,150 = $7,336 million

10. Which tax rate?

11. Capital expenditures should include • Research and development expenses, net of amortization. • Acquisitions of other firms, since these are like capital expenditures.

12. Amgen Net Capital Expenditures • If we define capital expenditures broadly to include R&D and acquisitions: • Accounting Capital Expenditures = $1,218 million • - Accounting Depreciation = $ 963 million • Accounting Net Cap Ex = $ 255 million • Net R&D Cap Ex = (3366-1150) = $2,216 million • Acquisitions in 2006 = $3,975 million • Total Net Capital Expenditures = $ 6,443 million

13. Working Capital Investments • In accounting terms, the working capital is the difference between current assets and current liabilities. • In valuation, it is the difference between non-cash current assets (inventory and accounts receivable) and non-debt current liabilities (accounts payable) • In estimating working capital changes, recognize that • They can be volatile • They can be negative (creating positive cash flows)

14. From FCFF to FCFE: Debt cash flows…. • In the strictest sense, the only cash flow that an investor will receive from an equity investment in a publicly traded firm is the dividend paid. • Actual dividends, however, are set by the managers of the firm and may be lower than the potential dividends (that could have been paid out) • The potential dividends of a firm are the cash flows left over after the firm has reinvested, paid taxes and covered debt payments. Net Income - (Capital Expenditures - Depreciation) - Changes in non-cash Working Capital - (Principal Repayments - New Debt Issues) = Free Cash flow to Equity