CHAPTER FOUR

Cash Accounting, Accrual Accounting, and Discounted Cash Flow

Valuation

Concept Questions

C4.1. The first sentence is true: dividends are the payoff to equity investing. The second

sentence is true in theory but not in practice. Equity value is the present value of the

infinite stream of expected dividends that a going concern generates. But, in practice, one

can’t forecast to infinity. Dividends paid over practical, finite forecast horizons are not

relevant to value. This is this dividend conundrum.

C4.2. If cash is king, his subjects are not well served. Look at the cash flows for General

Electric in Exhibit 4.2. Free cash flow does not incorporate accrual aspects of value

added. Free cash flow is reduced by investments, yet investment (typically) adds value.

Free cash flow is a liquidation concept, not a value-added concept.

C4.3. Not necessarily. A firm can generate higher free cash flow by liquidating its

investments. A highly profitable (and highly valuable) firm can have low (or even

negative) free cash flows because it is investing heavily to capitalize on its investment

opportunities. Again, see the GE example in Exhibit 4.2.

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Chapter 04 - Cash Accounting, Accrual Accounting, and Discounted Cash Flow Valuation
C4.4. Not necessarily. Cash flow from operations increased in 2003 over 2002, but the

2003 free cash flow was generated partially by a reduction in investment. This drop in

investment can be seen as bad news: Will the drop in investment harm future profits and

cash flows?

C4.5. The answer is (b). Matching cash received from sales with cash spent on inventory

does not match value received with value given up to earn the cash, because it recognizes

the cost of unsold good against the receipts from goods sold. Accrual accounting

accomplishes the matching because only the cost of goods sold is recognized against the

revenue from goods sold.

C4.6. The difference is explained by net (after-tax) interest payments and the total

accruals in earnings – the amount of earnings that does not involve cash flows:

Earnings = Cash from operations – net interest payments + accruals

See equation 4.12 and Box 4.7.

(The GAAP definition of cash from operations includes net interest payments,

inappropriately.)

C4.7. Free cash flow is earnings (before after-tax interest) minus operating accruals

minus cash investment in operations:

C – I (free cash flow) = Earnings + net interest payments – accruals – cash

investment

Or, as in equation 4.13 and Box 4.7,

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 Earnings = C – I - net interest payments + accruals + cash investment

C4.8. Because investment in T bills is an investment to store cash that temporarily is not

needed in operations. The investment in operations only comes when the T-bill is sold

and the cash from the sale is invested in operating assets.

C4.9. Levered cash flow is after net interest payments; as it involves interest from

financing activities, it is called a levered measure. Unlevered cash flow is cash from

operations without the any consideration of interest from financing activities. See

equation 4.10.

C4.10. Interest draws taxes; interest income incurs tax and interest expense yields a tax

deduction. So, to understand the effect of interest on earnings or cash flows, interest must

be attached to the interest to put it on an after-tax basis.

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Chapter 04 - Cash Accounting, Accrual Accounting, and Discounted Cash Flow Valuation

Exercises

Drill Exercises

E4.1. A Discounted Cash Flow Valuation

2009 2010 2011 2012

Cash flow from operations $1,450 1,576 1,718

Cash investment $1,020 1,124 1,200
Free cash flow $ 430 452 518

Discount rate (1.10)t 1.10 1.21 1.331

PV of cash flows 391 374 389
Total PV to 2012 $1,154
Continuing value* 8,979
PV of CV 6,746
a. Enterprise value $7,900 million
Net debt 759
b. Value of equity $7,141 million

518  1.04
* Continuing value =  8,989
1.10  1.04

E4.2. A Simple DCF Valuation

430
F
V2009 
1.10  1.05

= $8,600 million

E4.3. Valuation with Negative Free Cash Flows

Calculate free cash flow from the forecasts of cash flow from operations and cash
investments. Your will see that free cash flow is negative in all years except 2009:

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 2009 2010 2011 2012

Cash flow from operations 730 932 1,234 1,592

Cash investments 673 1,023 1,352 1,745
Free cash flow 57 ( 91) ( 118) ( 153)
If you calculate the present value of these free cash flows (with any discount rate), you’ll
get a negative price. Prices can’t be negative (with limited liability). The continuing value
must be greater than 100% of the price, but we have no way to calculate it. One would
have to extend the forecast horizon.

E4.4. Calculate Free Cash Flow from a Cash Flow Statement

Cash flow from operations reported $5,270

Interest payments $1,342
Interest receipts 876
Net interest payments 466
Tax at 35% 163 303
Cash flow from operations 5,573

Cash investments reported $6,417

Purchase of short-term investments (4,761)
Sale of short-term investments 547 2,203
Free Cash Flow 3,370

Applications

E4.5. Calculating Cash Flow from Operations and Cash Investment for Coca-Cola

Cash flow from operations:

Reported cash flow from operations $7,150

Interest paid $405
Interest received 236
Net interest paid 169
Tax deduction (at 36%) 61 108
Cash from operations $7,258 million

Cash investment:

Reported cash investment $6,719

Sale of investments $ 448

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Chapter 04 - Cash Accounting, Accrual Accounting, and Discounted Cash Flow Valuation
Purchase of investments (99) 349
Cash investment in operations $7,068

Coke’s free cash flow was $7,258 – 7,068 = $190.

E4.6. Identifying Accruals for Coca-Cola

Accruals are the difference between net income and cash flow from operations:
Accruals = $7,150 – 5,981
= -$1,169 million
That is, accruals were negative, yielding net income below cash flow from operations.

E4.7. Converting Forecasts of Free Cash Flow to a Valuation: Coco-Cola Company

Unlike the case in Exercise E 4.3, the free cash flows here are positive:
________________________________________________________________________
2004 2005 2006 2007

Cash flow from operations 5,929 6,421 5,969 7,258

Cash investments 618 1,496 2,258 7,068
Free cash flow 5,311 4,925 3,711 190

However, although positive, the free cash flow are declining over the four years. If cash
flows from operations and cash investments were declining at about the same rate,
we might conclude that the firm indeed was in a state of decline: declining cash
flows from the business lead to declining investments. However, cash flows from
operations are increasing and cash investment is increasing at a faster rate: Coke
is investing heavily. While free cash flow is declining over these years, one would
thus expect it to increase in future years as cash from the rising investment here
comes in. These cash flow are not a good indication of future free cash flows (and
nor is the $190 million of free cash flow in 2007 a good base to calculate a
continuing value.)

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 The exercise is a good example of why free cash flow does not work, in
principle: Investment (which is made to generate cash flows actually decreases
free cash flow, so rising investment relative to cash flow from operations (lower
free cash flow) typically means higher free cash flow later.

E4.8. Cash Flow and Earnings: Kimberly-Clark Corporation

Part a.

Adjust cash flow from operations for after-tax net interest payments and cash investment
for net investments in interest-bearing assets:

Cash flow from operations reported $2,969.6

Interest paid $175.3
Interest income (17.9)
Net interest 157.4
Tax on net interest (at 35.6%) 56.0 101.4

Cash flow from operations $3,071.0

Cash flow from investing reported $(495.4)

Net investment in debt securities (38) + 11.5 ( 26.5)
Net investment in time deposits 22.9 (499.0)

Free cash flow $2,572.0

Note: As cash interest receipts are not reported (as is usual), use interest income from the
income statement.

Part b.

Accruals = Net income – Cash flow from operations

= $1,800.2 – 2,969.6
= $(1,169.4)

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E4.9. A Discounted Cash Flow Valuation: General Mills, Inc.

a. The exercise involves calculating free cash flows, discounting them to present value,
then adding the present value of a continuing value. For part (a) of the question, the
continuing value has no growth:

2005 2006 2007 2008 2009

Cash flow from operations 2,014 2,057 2,095 2,107
Cash investment in operations 300 380 442 470
Free cash flow (FCF) 1,714 1,677 1,653 1,637
Discount rate 1.09 1.1881 1.2950 1.4116
Present value of FCF 1,572 1,411 1,276 1,160
Total of PV to 2009 5,419
Continuing value (CV) 18,189
PV of CV 12,885
Enterprise value 18,304
Net debt 6,192
Equity value 12,112

Value per share on 369 million shares = $32.82

1,637
CV (no growth) =  18,189
0.09
18,189
PV of CV =  12,885
1.4116

b. With growth of 3% after 2009, the continuing value is:

1,637  1.03
CV   $28,102
1.09  1.03
The present value of the continuing value is $28,102/1.4116 = $19,908.
Do the valuation is as follows:

Total of PV to 2009 5,419

Continuing value (CV) 28,102
PV of CV 19,908
Enterprise value 25,327
Net debt 6,192
Equity value 19,135

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Value per share on 369 million shares = $51.86.

E4.10. Free Cash Flow for General Motors

Appropriate free cash flow calculation:

2005 2004
Cash flow from operations reported $3,676 $12,108
Net interest $4,059 $3,010
Tax at 36% 1,461 2,589 1,084 1,926
$6,274 $14,034

Cash investment reported $(179) (24,209)

Net investment in debt securities (1,618) (1,797) ( 592) (24,801)

Free cash flow $4,477 $(10,767)

Mistakes by analyst:

1. Includes net sales of marketable (debt) securities as cash investment in

operations rather than sales of these securities to satisfy a cash shortfall. In
both years, there is more sales (liquidations) of these securities than
purchases, reducing reported cash investment.

2. Treats the liquidation of investments in companies (of $1,367 million in 2005)

as good news because it increases free cash flow. Selling off investments
increases current cash flow but reduces future free cash flows.

3. Treats increased sales of finance receivables (of $27,802 million in 2005) as

increasing free cash flow (and thus as good news). Sales of finance
receivables merely speed the receipt of cash. Booking the receivables from
customers is what adds value.

4. Treats the decrease in bookings of finance receivables (from a $31,731 million

increase in 2004 to a $15,843 million increase in 2005) as good news.

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E4.11. Cash Flows for Wal-Mart Stores

a. Wal-Mart is an expanding company with opportunities to invest in new stores

throughout the world. While it generates considerable cash flow from operations,

cash investments routinely exceed cash from operations. So free cash flow is

negative. This is a firm like General Electric in Exhibit 4.2. DCF analysis will not

work for this firm.

b. The difference between earnings and cash from operations is due net interest

(after-tax) and accruals.

The difference between earnings and free cash flows is due to net interest (after

tax), accruals and investments in operations.

c. DCF will not work. Negative free cash flows yield negative values.

E4.12. Accruals and Investments for PepsiCo

The question in this exercise tests accounting relation 4.12:

Accruals = Earnings – Levered cash flow from operations

= $4,212 - $5,054

= -$ 842 million

The second question modifies the investing section of the cash flow statement according

to equation 4.11:

Cash investments reported $2,330 million

Purchases of investments $1,007
Sales of investments 38 969
Cash investment in operations $1,361 million

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E4.13. Accrual Accounting Relations

(a) Cash = Revenues – Change in net receivables

= $405 – 32

= $373 million

(b) Change in payable = wages expense – cash wages

= $335 - $290

= $45 million

(c) PPE (end) = PPE (beginning) + Investment – Depreciation

 New Investment = Changes in PPE + Depreciation

= $50 + 131

= $181 million

E4.14. An Examination of Revenues: Microsoft

Cash revenue = Revenue reported – Change in Accounts

Receivable + Change in Unearned Revenue

= $36.835 – 0.694 + (-711)

= $35.430 billion

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Minicases

M4.1 Discounted Cash Flow Valuation: Coca Cola Company and Home
Depot, Inc.

Introduction

This case applies the DCF valuation to two firms, one where it works (somewhat) and the

other where is does not work well at all. Use the case to

 Demonstrate the mechanics of DCF valuation. Students are usually familiar with

the basic net present value techniques from other courses and can be relied upon

to do the calculations.

 Illustrate the difficulties in applying DCF analysis, particularly to Home Depot.

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  Demonstrate some of the adjustments that have to be made to the GAAP numbers

to calculate unlevered free cash flow from operations. (Chapter 10 expands on

further adjustments.)

 Compare free cash flow and earnings as measures of value added from operations.

Stress that free cash flow is partially a liquidation concept. See the material at the

end of the chapter.

 Set up the conceptual basis for moving to accrual accounting models.

 If this is the first valuation exercise of the course, discuss the issues involved in

calculating the cost of capital. Display some skepticism about guessing market

risk premiums. See appendix to Chapter 3.

You might consider Exercise E4.7 as an opener for this case. (The case actually ends up

with that example, but you could introduce it at the beginning.)

The Mechanics of DCF Valuation

The DCF model values the operations (the firm) by discounting expected free cash flows

and subtracting the value of the net debt. The mechanics are as follows:

1. Forecast free cash flow for each period ahead, t.

2. Discount each forecast with that period’s discount rate, ρt. The cost of capital

for both firms here is 1.09, so each period’s rate is 1.09t.

3. Calculate a continuing value at the forecast horizon

4. Discount the continuing value to present value.

5. Add 2 and 4

6. Subtract the value of the net debt, equal to debt obligations minus investments

in securities that absorb excess cash (debt investments here).

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Chapter 04 - Cash Accounting, Accrual Accounting, and Discounted Cash Flow Valuation
The chapter outlines how one might go about the forecasting, but note that, once

forecasted balance sheets and income statements have been reformulated along the lines

of Chapter 9, the forecast drops out very simply (as laid out at the beginning of the cash

flow chapter, Chapter 10). Here students are given the forecasts with actual cash flows, in

a hypothetical exercise where we pretend that we are standing at the beginning of 1999

and forecast the actual numbers for 1999-2001. This hypothetical exercise removes any

concern about imprecision in forecasting, for we have the actual numbers. Concerns arise

as to the validity of the methods, not the ability to forecast cash flows.

Question A: Calculating Free Cash Flow

GAAP statements of cash flow confuse financing with operations. After-tax net interest

must be added back to cash from operations, and net investments in securities that absorb

excess cash must be added back to cash investments to get cash investment in operations.

Here are the adjustments for Coke (KO):

1999 2000 2001

Cash flow from operations reported $3,883 $3,585 $4,110

Net interest payments $(61) $113 $(21)

Tax benefit (36%) 22 (39) (41) 72 8 (13)

Cash from operations 3,844 3,657 4,097

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Cash investments reported $3,421 $1,165 $1,188

Net “investments” (in securities) (342) (218) (1)

Cash investment in operating activities 3,079 947 1,187

Free Cash flow $ 765 $2,710 $2,910

Here are the adjustments for Home Depot (HD):

Years refer to fiscal year ending January following the year indicated.

1999 2000 2001

Cash flow from operations reported $2,446 $2,996 $5,963

Net interest payments $(11) $(31) $(35)

Tax benefit (39%) 4 ( 7) 12 (19) 14 (21)

Cash from operations 2,439 2,977 5,942

Cash investments reported $2,622 $3,530 $3,466

Net “investments” (2) (9) (60)

Cash investment in operation activities 2,620 3,521 3,406

Free Cash flow $ (181) $(544) $2,536

In both cases, net interest is interest payments minus interest income. (Ideally we would

like to have cash interest receipts rather than accrual interest income, but cash receipts are

rarely reported.) Net “investments” in securities to absorb excess cash is purchases of

securities minus proceeds from sale of the securities.

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Chapter 04 - Cash Accounting, Accrual Accounting, and Discounted Cash Flow Valuation
Attentive students might raise the issue of Home Depot’s capitalized interest. This

leads to a discussion of how GAAP further confuses operating and financing activities –

by including interest (a financing expense) as the cost of construction (an operating

asset). This issue is best left for later in the course, but note for now that the treatment is

difficult to disentangle for, while the adjustment can be made for the uncapitalized

interest (as we have done) and depreciated capitalized interest is added back to get cash

flow from operations, cash investment includes capitalized interest.

Question B: Valuation from Forecasts

Coke:

With only three years of forecasts, we have a problem calculating a continuing value

(CV). But there is some information on the pro forma here: free cash flow is growing at a

rate of 2,910/2,710 = 1.074 (7.4%) from 2000 to 2001. Let’s suppose that this rate were

to continue into the future. The CV based on 2001 free cash flow growing at 7.4% is

Continuing value = $2,910 x 1.074 = $195,334

1.09 – 1.074

Alternatively, as investment can affect the growth in free cash flow, we might base the

growth rate on the average growth rate of cash from operations over the three years,

about 3%;

Continuing value = $2,910 x 1.03 = $49,995

1.09-1.03
Emphasize to students that we are very much speculating about long-term growth rates

here. The financial statement analysis in Part II of the book is designed to give us a better

handle on growth rates (and thus reduce the speculation).

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The valuation of Coke under the first CV calculation is:

PV of 1999 cash flow $765/1.09 $ 702

PV of 2000 cash flow 2,710/1.188 2,281
PV of 2001 cash flow 2,910/1.295 2,247
PV of CV 195,334/1.295 150,837
Value of operations 156,067

Value of net debt (book value) 1,427

Value of equity 154,640

Value per share (on 2,465 million shares) $62.73

The value of net debt is the debt minus investment in debt securities. Book value

approximates market value.

The value of the equity is a little less than the market price of $67. The market is

pricing Coke as if it expects free cash flow to grow at more than a 7.4% rate after 2001.

The student can test the sensitivity of the valuation to a different cost of capital. Coca

Cola uses 9% internally as a hurdle rate for investment in operations.

Clearly we do not have much information here for assessing the growth rate. If

one used the CV with a 3% growth rate, the value would be considerably lower. At this

point discuss how further information and further pro forma analysis of Coke (sales

growth, margins, etc.) would help with formulating a growth rate. But the point is that

we at least have a starting point to investigate different scenarios. The DCF model looks

like something we can work with. Indeed, if we deemed that a 7.4% growth rate (in

perpetuity) is excessive (it is high!) and understand that the market is forecasting an even

higher rate, we may well conclude that Coke is overvalued, and need proceed no further.

Indeed, 1999 was a bubble period during which we may well have been skeptical about

valuations of such a “hot stock.” By 2001, after the 2001 report here was published, Coke

was trading at $45.

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Home Depot:

While the DCF model got us some insights into the valuation of Coca Cola, not so Home

Depot. Don’t even try to go through the mechanics of calculating the free cash flows for

HD. Free cash flows are negative for 1999 and 2000. If you go back in time prior to

1999, you will see that Home Depot’s free cash flows have been negative:

- $376 million, -$347 million, and -$15 million, in 1999, 1998, and 1997, respectively.

Free cash flows are positive for 2001, but the contributing factor is the large increase in

accounts payable and accrued liabilities of $2,078 million. Would we base a continuing

value on a firm slowing its payments to creditors for one period (which probably cannot

be sustained)?

As further examples, refer the cash flows for GE in Exhibit 4.2 and those for Wal-

Mart Stores in Exercise E4.11.

Shipping Ahead to 2004

The cash flows to consider now are:

________________________________________________________________________
2004 2005 2006 2007

Cash flow from operations 5,929 6,421 5,969 7,258

Cash investments 618 1,496 2,258 7,068
Free cash flow 5,311 4,925 3,711 190

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Here we run into similar problems with Coke here as we did with HD. Although positive,
the free cash flows are declining over the four years. If cash flows from
operations and cash investments were declining at about the same rate, we might
conclude that the firm indeed was in a state of decline: declining cash flows from
the business lead to declining investments. However, cash flows from operations
are increasing and cash investment is increasing at a faster rate: Coke is investing
heavily. While free cash flow is declining over these years, one would thus expect
it to increase in future years as cash from the rising investment here comes in.
These cash flow are not a good indication of future free cash flows (and nor is the
$190 million of free cash flow in 2007 a good base to calculate a continuing
value.)
This is another example of why free cash flow does not work, in principle:
Investment (which is made to generate cash flows actually decreases free cash
flow, so rising investment relative to cash flow from operations (lower free cash
flow) typically means higher free cash flow later.
Discussion

The chief discussion point of the case is the concept behind free cash flows. See that

section in the chapter. Free cash flow is a liquidation concept, so that a profitable firm,

like Home Depot, that invests heavily to take advantage of its profit opportunities, has

negative free cash flow. HD is similar to the General Electric example in the chapter. A

firm that liquidates its investments (possibly destroying value) increases free cash flow.

The measure is perverse. It does not capture value added.

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Chapter 04 - Cash Accounting, Accrual Accounting, and Discounted Cash Flow Valuation
At this point, introduce accrual accounting and show how it deals with investment

and, in addition, attempts to correct the mismatching of value added and value

surrendered that is the problem with free cash flow. Look at the net income for HD

reported at the top of the cash flow statement. These numbers are positive (for a start),

but are also growing at a rate that can be a base for forecasting subsequent growth rates.

However, to proceed, we require a model that converts earnings forecasts to a valuation.

Financial statements for presenting the case are below.

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