Depreciation and Capital Expenditure

Question 1. The table below contains entries from the income statement of a hypothetical
company – Imperial Machines – over 6 years.

Table 1: Excerpts from the Income Statement of Imperial Machines

The next table records the relevant line form the Cash Flow Statement (note capital expenditures
are recorded with a negative sign).

Table 2: Excerpts from the Cash Flow Statement of Imperial Machines

If the machines are assumed to have a 3 year life, and were bought at the beginning of the period so
depreciate in the year that they were bought, and using a simple straight line depreciation rule
then:

a) Complete the Income statement above assuming a tax rate of 40% on all operating income
after interest?

b) Repeat the exercise, but now assume the capital expenditure is treated as a cost of doing
business and the full cost is recognised in SG&A in the same year as the expenditure?
 c) What difference does this accounting treatment imply for the total tax payments of Imperial
Machines?

Working Capital and Short Term Accruals

Question 2. IConia – high tech company – can pay suppliers in the quarter after it has sold to
customers. IConia has 25% net profit margin and is reporting the following in its quarterly reports

1Q1 1Q2 1Q3 1Q4 2Q1

Income Statement Reported Sales £0 £100 £100 £400 £0
Income Statement Reported Net Income £0 £25 £25 £100 £0
Balance Sheet Reported Accounts Payable £0 £75 £75 £300 £0

a) What are IConia quarterly cash flows taking Accounts Payable into account?
b) How does the timing and the value of the cash flows after accounting for payables differ
those of net income?

IConia offered some trade credit to its clients after it suffered a slower growth in sales than
expected. These are detailed in the table below

1Q1 1Q2 1Q3 1Q4 2Q1

Balance Sheet Stock of Inventory £0 £30 £60 £10 £0
Balance Sheet Reported Accounts £0 £20 £50 £100 £0
Receivable

c) What are the actual IConia quarterly cash flows?

Putting it all together

Question 3. Jeremy is setting up a window cleaning business. He set up a limited company – Jeremy
Sparkles (JS) Ltd - and sell shares to his family for £50,000. He also receives a loan of £80,000 from
his local bank branch which will charge him 20% a year in 4 equal quarterly instalments.

With this capital, he rents office space for a downpayment of £12,000 for 3 years (that is a rate of
£1,000 per quarter paid up front). He buys a truck for £100,000 which he expects will last for 5 years
(20 quarters). Finally he hires two employees, one to work in the office and one window cleaner;
both to be paid £20,000 a year.

In the 1st quarter, the business is successful and wins 2 large contracts with 2 local companies which
each pay £20,000 to clean their respective office windows per quarter. The bills are to be paid within
90 days (1 quarter). In the next quarter, the business continues to go well on the same cleaning
contracts. Assume there are no further expenses apart from the wage bill. In addition – to keep
things simple – assume no taxes and no dividends (all earnings are retained) and all bills are paid at
the end of the 90 day period.

a) Construct a cash flow account for the 1st and 2nd quarters (use a direct approach and do not
worry too much about the line labels). It is the split into Cash Flow from operations (CFO), Cash
flow from Investing (CFI) and Cash Flow from Financing (CFF) that is important.

b) Now construct an income account for the same quarters assuming straight line depreciation of
the truck over the 20 quarters. Again do not worry too much about the labels though please
include an operating and net income line.

c) Finally set up a balance sheet for the Jeremy Sparkles Ltd for the end of each of the first two
quarters.

d) Given time, rewrite the cash flow statement using an indirect approach, i.e. off the income
statement.

Calculating the Net Operating Assets and Net Debt

Question 4. We will look at Sainsbury’s in detail later in the course. But here is the balance sheet of
their core retail business. (The items relevant to Sainsbury’s Bank have been removed. We will
discuss later the difficulty of valuing a bank).

Table 3: The Balance Sheet of Sainsbury’s Plc. ex Sainsbury’s Bank (2019-2022). Source S&P
Capital IQ.

2019 2020 2021 2022

Cash and Short Term Investments 466 447 546 436
Accounts Receivables, Total 284 444 570 511
Inventory and Prepaid Expenses 2,093 1,900 1,780 1,969
Other Current Assets1 211 215 29 86
Total Current Assets 3,054 3,006 2,925 3,002
Net Property, Plant & Equipment 14,186 13,775 13,334 13,962
Gross Property, Plant & Equipment 20,021 19,904 19,690 20,541
Accumulated Depreciation (minus) -5,835 -6,129 -6,356 -6,579
Goodwill and Other Intangibles 1,043 974 914 1,006
Other Long-Term Assets2 1,025 1,168 802 2,561
Long-term Investments 439 261 312 385
 Total Assets 19,747 19,184 18,287 20,916
Accounts Payable 3,044 2,960 2,873 2,965
Accrued Expenses 768 470 544 613
Short-term Borrowings 136 - 99 7
Current Port. of LT Debt/Capital
Leases 1,230 611 874 602
Other Current Liabilities3 874 1,116 1,353 1,237
Total Current Liabilities 6,052 5,157 5,743 5,424
Long-Term Debt and Leases 6,159 6,548 6,102 6,805
Deferred Income Tax4 235 265 255 806
Other Non-Current Liabilities5 182 100 170 195
Total Liabilities 12,628 12,070 12,270 13,230
Share Capital 3,674 3,689 3,440 3,663
Retained Earnings 3,445 3,425 2,577 4,023
Total Equity 7,119 7,114 6,017 7,686
Total Liabilities + Equity 25,799 19,184 18,287 20,916

As with all accounts some of the line items have been aggregated and it is necessary to look in the
notes to the financial accounts to find out precisely what is in these line items. Based on this please
make the following assumptions.

Notes to the Balance Sheet:

1. Other Current Assets: This is a gain in the fair value of derivative assets - treat as a
cash/investment, it is interest bearing and not required for core operations
2. Other Long-Term Assets: This is primarily the surplus in the pension fund - treat as an
investment, interest bearing and not used in core operations
3. Other Current Liabilities: This is primarily Other Trade Payables. It is non-interest bearing, part of
core operations and should be included in NOWC
4. Deferred Income Tax: It is not interest bearing. We will therefore treat as part of NOWC. As part
of NOWC it is paid out of future cash flows. We note some analysts treat deferred tax as part of
debt. In this case it is part of the enterprise value as it is treated as borrowing.
5. Other Non-Current Liabilities: This is provisions for non-payment (on Argos cards and to a lesser
extent property rents). It is non-interest bearing, part of core operations, hence treat as NOWC.

Please note that these assumptions are open to some discretion. Some analysts will make different
assumptions. But either way, the important thing is to make sure that the assumptions you make
are consistent with the estimation of the Free Cash Flows to the core operations.

Based on these instructions, calculate the Net Operating Working (NOWC), Net Operating Assets
(NOA), the Net Debt and Invested Capital for Sainsbury’s retails business for the years 2019- 2022.

And finally calculating the Free Cash Flow (FCF)

Question 5. Tanaka enterprise reports the following income statement (in millions of Dollars):

2012 2011 2010

Sales 200 162 150
 - COGS 60 58 57
-SG&A 20 19 18
=Operating Income 120 85 75
- Net Interest 35 35 35
-Taxes 34 20 16
=Income after Tax 51 30 24
- Extraordinary Items 0 0 0
=Net Income 51 30 24

And the following line items in its Cash Flow and Balance Sheets

2012 2011 2010

Cash Flow Statement Capital Expenditure 0 30 200
Cash Flow Statement Depreciation 25 23 20
Balance Sheet Deferred Tax Liability 20 16 10
Balance Sheet Accumulated Depreciation 68 43 20
Balance Sheet Accounts Receivable 10 8 5
Balance Sheet Inventory 30 23 20
Balance Sheet Accounts Payable 5 6 5

Calculate the Unlevered Free Cash Flow (FCF) or Cash Flow from Assets (CFFA) of Tanaka enterprise
in 2011 and 2012 ?

Deferred Taxes (tricky and for interest only)

Question 6. In the UK to encourage investment, HMRC allow an accelerated depreciation of an asset

for tax purposes. In fact they sometime allow for 100% of the capital expenditure to be depreciated
in the first year (this is called 100% First Year Allowance FYA).

a) Return to Question 1, and calculate both the accrued (these can be negative) and the actual
tax payments made by Imperial Machines to HMRC in their tax statement given
i) 100% FYA for any capital expenditure
ii) And that any tax losses can be carried forward to reduce actual cash payments in a
following year.

The difference between the reported tax payments in the financial statement and the accrued cash
payments in the tax statement is a non-cash payment on the financial income statement. The
accumulated sum of these payments is reported as a liability on the balance sheet – much the same
way as accounts payable.

b) Calculate the value of this liability – labelled sometimes as Taxes Payable or Deferred Tax
Liability – on the balance sheet of Imperial Machines.