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Lecture 10

FINA 410 Lecture 10: Chapter 10 – From Earnings to Cash Flows

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FINA 410
Jean Mayer

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Chapter 10 From Earnings to Cash Flows Why cash flows? Because the value of an asset comes from its capacity to generate cash flows. When valuing firm: cash flows should be after taxes reinvestment but before debt payments When valuing equity: cash flows should be after debt payments 3 basic steps to estimating cash flows: 1. Estimate the earnings generated by a firm on its existing assets and investments (previous chapter) 2. Estimate the portion of this income that would go towards paying taxes 3. Develop a measure of how much a firm is reinvesting back for future growth Chaper focus is on last two steps: o Start with investigating the difference between effective marginal taxes, as well as the effects of net operating losses carried forward o To know how much a firm is reinvesting, we will break it down into: (Net Capital expenditures): tangible and longlived assets (Working Capital): short term assets Reinvestment will include investement in RD and acquisitions as part of CAPEX The Tax Effect Aftertax operating income= EBIT * tax rate This is complicated by 3 issues: 1. The wide differences you observe between effective and marginal tax rates for these firms: which to choose? Effective Tax Rate = _ Taxes Due . Taxable Income 2. Firms with large losses: leading to net operating losses that are carried forward and can save taxes in future years 3. The capitalizing of RD and other expenses: because these expenditures can be expensed immediately they have much higher tax benefits for the firm Effective Versus Marginal Tax Rate Choice between the two tax rates: Choice 1: Effective tax is the most widely reported tax rate, computed from the income statement as follows: Effective tax rate = Taxes Due . Taxable Income Choice 2: Marginal tax rate is the tax rate the firm faces on its last dollar of income o Reflects what firms have to pay as taxes on their marginal income
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