This page lists recent articles related to corporate finance on this website.
The present value concept discounts the cash flows of a period by the entire period using the discount rate. The DCF valuation method relies on the present value concept to value the cash flows of a business. Therefore the DCF valuation method also discounts the cash flows of a period by the entire period using the discount rate. However, this may not be an appropriate reflection of reality.
And thus enters the mid year convention!
Business cycles are part and parcel of life in certain industries. An excellent example of industries that have cycles is commodities. Another example is the shipping industry. Are these business cycles considered abnormal events? Are they required to be normalized? If they are to be normalized, how do you normalize them?
Normalization of earnings is done for prior years to understand the cash flows generated by the core business in a normal year. Every year brings surprises. If these surprises are random one-off events that are not likely to occur, it is considered abnormal and removed to reflect what the earnings may have been in a normal year. Normalization is done to help you estimate future operating cash flows to use in a DCF valuation.
Earnings that reflect a typical year is considered “normalized” earnings. Every year brings surprises. If these surprises are random one-off events that are not likely to occur, it is considered abnormal and removed to reflect the earnings in a normal year.
Events considered abnormal and removed to normalize earnings may be positive (income) or negative (expenses) events.
Examples of events that need normalization:. Examples of expenses that are adjusted in normalizing earnings include litigation fees, unusual discretionary expenses, one of penalties and fines. Examples of income that are adjusted in normalizing earnings include awards received, unusual and one of projects, etc.
In preparing a DCF valuation, you often use the current EBIT as a base to arrive at future cash flows. However, EBIT includes all income and expenses that the company has encountered. This includes items that are regular and recurring and those that are irregular and may not occur. When we are valuing a company, we only what to know what the cash flows are likely to be in the future. Only cash flows that we can expect to occur again from today onward provide us value. Therefore, the EBIT must reflect only items that you will expect in the future.
The portion of R&D spend that is capitalized is usually only a small part of R&D. However, most companies benefit from R&D spending in the form of acquired know-how. This acquired know-how is a valuable asset that produces cash flow in the future. Analysts and investors should want the value of R&D spending in the balance sheet. So R&D should be treated like another investment and the R&D spending capitalized like other assets such as an investment in a building. But how do you capitalize R&D expenses? What are the steps involved in capitalizing R&D expenses?
This article discusses the steps involved in capitalizing R&D expenses.
Background: Accounting regulation requires research and development expenses be considered an operating expense and written off in the income statement. There are specific exceptions to this rule. For example, when a product has become commercially feasible in the pharmaceutical industry, all associated costs can be capitalized and considered a capital asset. This capital asset can then be reflected in the balance sheet. The difficulty in accurately valuing the benefits of R&D and the duration of the associated benefits is a primary reason that R&D is not capitalized. But why is this a bad practice from a DCF valuation practice?
This article discusses why is expensing R&D expenses is a bad practice from a DCF valuation perspective.
Depreciation is the allocation of the cost of a tangible fixed asset over its useful life. Amortization is the allocation of the cost of an intangible asset over its useful life. In both cases, there is no cash flow associated with these assets after the year of purchase and so should not affect your cash flows in a DCF valuation. However, both depreciation and amortization become relevant in a DCF valuation under specific conditions. Only under specific conditions is there a difference between depreciation and amortization from a DCF valuation perspective.
This article discusses the specific conditions when there will be a difference between depreciation and amortization from a DCF valuation perspective.
In principle, if an operating lease is genuinely an operating expense, it must continue to be shown as an expense and treated accordingly. However, if it was structured to avoid taking on debt, it must be capitalized. Capitalized simply means that it must be treated as a capital asset.
In practice, you treat the operating lease in accordance with the rules prescribed by the SEC. We address the steps required to capitalize an operating lease on this page
Companies can either buy or lease assets it needs on a long-term basis. For example, a firm can buy a truck required for the business or lease the truck. A company usually leases a long-term asset if it either 1) does not have the money to buy it and 2) does not want to borrow the capital required to buy these assets. The business case should be the driver of this decision. Sometimes, companies may lease the asset because it does not have money to buy the asset or wants to avoid taking on more debt. The SEC has prescribed accounting rules that specify the conditions required to treat a lease as an operating expense or a capital item.
SEC regulations aside, we address how you should deal with operating leases when preparing cash flows for a DCF valuation on this page.