With the info given, did I do the balance sheet and income statement and calculate CFFA and intrinsic value correctly?

Assume that a public corporation has 5,000,000 shares outstanding. First, you are to create the necessary Balance Sheets and Income Statements and then calculate the annual Cash Flow from Assets (aka: CFFA or Free Cash Flows (FCF)) for this corporation by way of its three components (operating cash flows, capital spending, and changes in net working capital). A constraint here is that your CFFA must range between $12,000,000 and $13,000,000 annually. Second, after calculating CFFA, you are to assume that this corporation is a no-growth perpetuity and estimate its present value (aka: intrinsic value). Assume the market determined risk adjusted required rate of return is 9.125% for this corporation. Said another way, you are to replicate and explain the relevant parts of the textbook, notes, and lectures associated with CFFA and intrinsic value of the firm estimations. Teach me the concepts.

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Answer 1 / Part 1: Cash Flow from Assets

The way the problem is written requires some assumptions in order to solve it. First, since the tax rate is not provided, Net Income and calculations that depend on a corporate tax rate cannot be computed. For this reason, the Tax Rate () will be defined at 35%.

Once a Balance Sheet and Income Statement are created, that will allow us to calculate the annual Cash Flow from Assets (CFFA). At that point, we are generating the information needed to engage in the fundamental objective of corporate finance - the valuation of financial assets. As we start, it is always helpful to remember that:

The Current Market Value for any Real or Financial Asset is the Present Value of the Cash Flows Accruing to that Asset Discounted by a market-determined, Risk-adjusted Required Rate of Return, with an exception for options which are priced via Risk-free, no-arbitrage arguments.

Thus, balance sheets and income statements will provide the Cash Flows accruing to that Asset.

The Balance Sheet is a statement of the assets, liabilities, and capital of a business organization at a point in time. It is a snapshot of a specific moment in the firms history. It would be different if taken the day before the date of the statement, or the day after. It answers the questions of what does a firm own and what it owes with the difference being its equity.

First, we will use the assumptions of the question to create the Balance Sheet for our case project The Cutting Edge, Inc. We have assumed that the firm had total assets of $17,440,000₂₀₁₄ and $21,400,000₂₀₁₅, and have distributed those among current and fixed assets (Let M = million or millions).

Second, to be able to calculate the annual Cash Flow from Assets (CFFA) or Free Cash Flows (FCF), we must build an Income Statement for the year ended December 31, 2015. Our statement assumes Net Sales of $67,550M, with Earnings before interest and taxes of $38,420M, and Net Income of $22,475,700.

This results in the Balance Sheet and Income Statement for The Cutting Edge, Inc. found in Exhibits 1.1 and 1.2 on the following page:

The Cutting Edge 2015 & 2016 Balance Sheets
Assets			Liabilities and Owners Equity
	2016	2015		2016	2015
Current assets			Current Liabilities
Cash	$8,000,000	$10,000,000	Accounts Payable	$8,000,000	$10,000,000
Accounts Receivable			Notes Payable	$15,000,000	$16,000,000
Inventories			Total Current Liabilities	$23,000,000	$26,000,000
Total Current Assets	$54,000,000	$64,000,000
			Long Term Debt	$50,000,000	$51,000,000
Fixed Assets
Property, Plant, Equipment	$57,000,000	$72,000,000
			Owner's Equity
			Common Stock	$16,000,000	$17,000,000
			Retained Earnings	$22,000,000	$42,000,000
Total Assets	$111,000,000	$136,000,000	Total Liabilities and Owners Equity	$111,000,000	$136,000,000

Exhibit 1.2 Income Statement for The Cutting Edge, Inc. 2015
The Cutting Edge, Inc.
2015 Income Statement
Net Sales		$67,550,000
Cost of Good Sold		$7,980,000
Gross Profit		$66,752,000
Depreciation		$4,800,000
EBIT		$66,272,000
Interest Paid		$3,842,000
Taxable Income		$62,430,000
Taxes (35%)		$12,445,300
Net Income		$49,984,700
Dividends		$24,200,700
Addition to Retained Earnings		$25,784,000

The calculation of CFFA involves three key components:

Operating Cash Flows (OCF): reflecting the dollar value of the day-to-day companys activity of what they produce and sell. In this calculation we are solving for the revenues of the firm minus the cost of the goods sold. It is important to remember that this calculation only reflects the Revenue of the firm minus the cost of that revenue. Therefore, we add Depreciation back (since this is not a real cash outflow) and subtract interests (because this is a financing expense) as shown in exhibit 1.3.

Exhibit 1.3 Operating Cash Flows (OCF) The Cutting Edge, Inc. 2015
The Cutting Edge
2015 Operating Cash Flow
EBIT		$66,272,000
+ DEPRECIATION		$4,800,000
- TAXES		$12,445,300
OPERATING CASH FLOWS		$58,626,700

2. Capital Spending: reflecting the Net Spending on fixed assets or the difference between what was spent on fixed assets minus what was received from the sale of those assets. For this calculation, the Beginning Net Fixed Assets (NFA) for 2015 will be equal to the ending NFA of 2014, and it is necessary to adjust this value for Depreciation as shown in exhibit 1.4.

Exhibit 1.4 Capital Spending The Cutting Edge, Inc. 2015
The Cutting Edge
CAPITAL SPENDING 2015
ENDING NET FIXED ASSETS 2015
LESS BEGINNING NET FIXED ASSETS 2015
PLUS DEPRECIATION
NET CAPITAL SPENDING

3. Changes in Net Working Capital (NWC): reflecting the change on investment in current assets as well as the change of their current liabilities. NWC is positive when the current assets are bigger than the current liabilities. A healthy firm usually will have enough current assets to cover their current obligations. The beginning Net Working Capital for 2015 is equal to the Ending NWC of 2014, thus for the calculations of the 2014/2015 NWC we will use:

=

=

Exhibit 1.5 Changes in Net Working Capital 2015
The Cutting Edge, Inc.
CHANGES IN NET WORKING CAPITAL
ENDING N.W.C 2015
LESS BEGINNING N.W.C. 2015
CHANGE IN N.W.C.

can now be estimated as shown in Exhibit 1.6

Exhibit 1.6 Cash Flow From Assets 2015
The Cutting Edge
2015 CFFA
OPERATING CASH FLOW
LESS NET CAPITAL SPENDING
LESS CHANGES IN N.W.C
CFFA 2015

3. The CFFA is the cash flow that will be used to estimate the intrinsic value of The Cutting Edge. On the other hand, a second definition calculates CFFA by adding up cash flows going back to creditors and the cash flows that go to stockholders as shown in Exhibit 1.7.

Finally, as we learned in class, there is another way to calculate Cash Flow from Assets (CFFA), or as some prefer Free Cash Flows (FCF). This calculation is based upon the cash that the firm is free to distribute to creditors and stockholders during the year.

Exhibit 1.7 Cash Flow Identity 2015
The Cutting Edge, Inc.
2015 Cash Flow to Creditors
Interest paid
Long term debt 2015 $2,830,000
-Long term debt 2014 -$1,590,000 Net Borrowing 2015 $1,240,000
Cash Flow to Creditors
2015 Cash Flow to Equity Holders
Dividends paid
Common equity 2015 $ 11,100,000
-Common equity 2014 $ 8,800,000
Net Equity Raised 2015 $ 2,300,000
Cash Flow to Equity Holders

= $ 24,502,700

Answer 1 / Part 1: Calculating annual Cash Flow from Assets

Cash Flow from Assets (CFFA) is the same thing as Free Cash Flows (FCF). It is helpful to start with a summary of the various cash flow calculations, as a road map for the answer to Part I:

The Cash flow identity is Cash flow from assets = Cash flow to creditors (bondholders) + Cash Flow to stockholders (owners). To better understand how each of these elements is defined we drill down to the next level of detail.

Finally, as we learned in class, there is another way to calculate Cash Flow from Assets (CFFA), or as some prefer Free Cash Flows (FCF). This calculation is based upon the cash that the firm is free to distribute to creditors and stockholders during the year.

Cash flow to creditors (bondholders)

Cash flow to creditors = Interest paid Net new borrowing

From our Income Statement in Exhibit 1.2, we find that Interest was paid in the amount of $3,842,000 to the firm's creditors. From our Balance sheets in Exhibit 1.1, we see that long-term debt increase by $2,830,000 $1,590,000 = $1,240,000. Therefore, with the following formula, we can calculate the cash flow to the creditors of The Cutting Edge, Inc.

Exhibit 1.7A details this information.

Exhibit 1.7A Cash Flow to Creditors

ABC Inc.
2015 Cash Flow to Creditors
Interest paid
- Net new borrowing		$1,240,000
Cash flow to creditors

Cash flow to stockholders (owners)

As noted in our Income Statement in Exhibit 1.2, dividends paid to stockholder amounted to $24,200,700. To find net new equity raised, we look at the common stock and paid-in surplus account in Balance sheets, which totals $2,602,000. Therefore, with the following formula, we can calculate the cash flow to the Stockholders of ABC Inc.

Exhibit 1.7A details this information.

Exhibit 1.7B Cash Flow to Stockholders

The Cutting Edge Inc.
2015 Cash Flow to Stockholders
Dividends paid
- Net new equity raised		$2,602,000
Cash flow to stockholders

When we add the cash flows to creditors of $2,602,000 to the cash flows to stockholders in the amount $24,200,700, we find that CFFA for 2015 is $21,598,700.

(I)

(II)

With and . We know that converges to as n approaches. Create a numerical example to show that this is so and explain the relevance of this convergence with respect to the estimation of financial asset valuation. Teach me the concepts.