Chapter 18, Problem 10CP

a.

Summary Introduction

To determine: The two adjustments that has to be made by Share in order to obtain the free cash flow to equity from the cash flow from operations statements.

Introduction:

Free cash flow to equity: When we have to know the cash available to the equity shareholders of a company, we need a measure like free cash flow to equity.  The availability of cash after clearing all sorts of expenses, reinvestments, payments of debts, etc., has to be shared with the equity shareholders of the company. 

Answer to Problem 10CP

The free cash flow to equity can be derived by making adjustments such as deduction of capital expenditure and addition of net borrowings from/to cash from operations.

Explanation of Solution

The free cash flow to equity is the amount of cash available to equity. It is measure of amount of capital usage. Free cash flow to equity can be categorized as a measure exclusively meant for equity capital usage.

Table 18H RIO National Corp. supplemental notes for 2017

Note 1:	Rio National had $75 million in capital expenditures during the year.
Note 2:	A piece of equipment that was originally purchased for $10 million was sold for $7 million at year-end, when it had a net book value of $3 million. Equipment sales are unusual for Rio National.
Note 3:	The decrease in long-term debt represents an unscheduled principal repayment, there was no new borrowing during the year.
Note 4:	On January 1, 2017, the company received cash from issuing 400000 shares of common equity at a price of $25.00 per share.
Note 5:	A new appraisal during the year increased the estimated market value of land lend for investment by $2 million, which was not recognized in 2017 income.

The formula of free cash flow to equity is as follows:

  $FreeCashFlowToEquity=CashFromOperations-CAPEX+NetDebtIssued$

Knowledge of cash, availability is a must. Cash from operations is also called operating from cash; free cash flow from operations, cash flow from operating activities. It refers to the amount that is generated from the revenues earned by the company.  Let us now discuss the adjustments required to be made by Mr. Shaar.

1.      To deduct the capital expenditure from the cash from operations: There are two types of expenses namely, recurring expenses and capital expenditure.  Recurring expenses are those expenses which reoccur whereas the capital expenditure is that expenditure which is normally made for one time.  For instance, purchase of machinery for the company is a capital expenditure as even though the amount is paid towards the purchase of machinery, the benefit earned from the machinery is for a long term.  So, more than a purchase, we can consider this expenditure as a long-term investment activity.  When such expenditures are deducted from the cash from operations, we can obtain the free cash flow to equity.  Capital expenditures are deducted as they are not shared with the equity shareholders.

2.      Addition of net borrowings to cash flow from operations:  Even though borrowing refers to a debt, when an amount is borrowed, it can be utilized to fulfill many business activities.  One such activity is repayment of debt.  So, whatever balance is remaining after clearing the debts, the balance amount has to be added to cash from operations.  This will increase the cash flow for equity.

b.

Summary Introduction

To determine: The adjustment to be made to net income in the given five supplemental notes to calculate Rio National’s free cash flow to equity for 2017.

Introduction:

Free cash flow to equity: When we have to know the cash availability to the equity shareholders of a company, we need a measure like free cash flow to equity. The availability of cash after clearing all sorts of expenses, reinvestments, payments of debts etc., has to be shared with the equity shareholders of the company. Therefore, free cash flow to equity can be categorized as a measure exclusively meant for equity capital usage.

Answer to Problem 10CP

The free cash flow to equity can be derived by making adjustments while calculating the net income.

Explanation of Solution

The free cash flow to equity is the amount of cash available to equity. It is measure of amount of capital usage. Free cash flow to equity can be categorized as a measure exclusively meant for equity capital usage.

The information given to us is as follows (extracted from problem 9):

Table 18H RIO National Corp. supplemental notes for 2017

Note 1:	Rio National had $75 million in capital expenditures during the year.
Note 2:	A piece of equipment that was originally purchased for $10 million was sold for $7 million at year-end, when it had a net book value of $3 million. Equipment sales are unusual for Rio National.
Note 3:	The decrease in long-term debt represents an unscheduled principal repayment, there was no new borrowing during the year.
Note 4:	On January 1, 2017, the company received cash from issuing 400000 shares of common equity at a price of $25.00 per share.
Note 5:	A new appraisal during the year increased the estimated market value of land lend for investment by $2 million, which was not recognized in 2017 income.

When we see the given information, we find that five different supplemental notes are given to us. We are supposed to explain about the adjustment to made to derive the net income. This net income is required to calculate the Free cash flow to equity for the year 2017.

The information given to us is as follows(extracted from problem 9):

Table 18H RIO National Corp. supplemental notes for 2017

Notes	Narration	Adjustment to derive the free cash flow to equity
Note 1:	Rio National had $75 million in capital expenditures during the year.	We have to deduct $75 million from cash from operations
Note 2:	A piece of equipment that was originally purchased for $10 million was sold for $7 million at year-end, when it had a net book value of $3 million. Equipment sales are unusual for Rio National.	The cash flow after sale of equipment is $7 million. Since $4 million has already been considered in the net income, the balance of $3 million should be added back to the cash from operations.
Note 3:	The decrease in long-term debt represents an unscheduled principal repayment, there was no new borrowing during the year.	Total debt= $245 million in 2016 Total debt = $240 million in 2017. This means $5 million debt have been repaid. So, $5 million has to deductedfrom net income.
Note 4:	On January 1, 2017, the company received cash from issuing 400000 shares of common equity at a price of $25.00 per share.	In this case, no adjustment is required because issue of shares have no effect on free cash flow available to equity shareholders.
Note 5:	A new appraisal during the year increased the estimated market value of land lend for investment by $2 million, which was not recognized in 2017 income.	In this case, no adjustment is required because the increase in estimated value of land is not generating any cash flow. So it was not included in the net income.

c.

Summary Introduction

To calculate: Rio National’s free cash flow to equity for the year 2017.

Introduction:

Free cash flow to equity: When we have to know the cash availability to the equity shareholders of a company, we need a measure like free cash flow to equity. The availability of cash after clearing all sorts of expenses, reinvestments, payments of debts etc., has to be shared with the equity shareholders of the company. Therefore, free cash flow to equity can be categorized as a measure exclusively meant for equity capital usage.

Answer to Problem 10CP

Rio National’s free cash flow to equity for the year 2017will be $ 0.33 million.

Explanation of Solution

The free cash flow to equity is the amount of cash available to equity. It is measure of amount of capital usage. Free cash flow to equity can be categorized as a measure exclusively meant for equity capital usage.

The information given to us is as follows(extracted from problem 9):

Table 18H RIO National Corp. supplemental notes for 2017

Note 1:	Rio National had $75 million in capital expenditures during the year.
Note 2:	A piece of equipment that was originally purchased for $10 million was sold for $7 million at year-end, when it had a net book value of $3 million. Equipment sales are unusual for Rio National.
Note 3:	The decrease in long-term debt represents an unscheduled principal repayment, there was no new borrowing during the year.
Note 4:	On January 1, 2017, the company received cash from issuing 400000 shares of common equity at a price of $25.00 per share.
Note 5:	A new appraisal during the year increased the estimated market value of land lend for investment by $2 million, which was not recognized in 2017 income.

Working note: Calculation of increase in working capital:

Let us now calculate the increase in working capital.

  $\begin{array}{l}IncreaseInWorkingCapital=IncreaseInCurrentAssets+DecreaseInCurrentLiabilities\\ \Rightarrow (IncreaseInAccounts\mathrm{Re}ceivable+IncreaseInInventory)+DecreaseInCurrentLiabilities\\ \Rightarrow [(30-27)+(209.06-189.06)]+(26-25)\\ \Rightarrow 3+20+1=24\end{array}$

Therefore the net increase in working capital is 24.

Calculation of free cash flow to equity per share for the year 2017.

Particulars	Amount ($ in millions)	Amount ($ in millions)
Net income		30.16
Add: Depreciation	71.17
Add: Cash proceed from sale of equipment ($7-$4)	3	74.17
Sub total		104.33
Less: Net capital expenditure	75
Less: Increase in working capital − (Working note)	24
Less: Long term debt paid (245-240)	5	104.00
Free cash flow in 2017		0.33

Note: The items that has to be added are done and a collective figure is considered in the 3^rd column. Similarly, the items to be deducted are done and a collective figure is considered in the 3^rd column.

Therefore, from the above calculation, it is clear that the free cash flow in 2017 will be $ 0.33 million.