Net Borrowing For FCFE

On Mock 2011 Afternoon #51, both Notes Payable and LTD are increasing, and CFAI shows the answer to solve net borrowing as Net LTD minus Net Notes Payable. When reading the books and looking at Schweiser, it appears you should be summing the two.

Any ideas?

there are 2 problems with CFAI’s answer of quez51

first, WCinv should exclude Note payables

Second, as u said, note payables should be included in Net borrowing

I think it’s kind of errata

anyone else?

Yes, it’s an errata. You can go search for it.

Just need to take note that working capital does not include monetary current asset or liability (cash, marketable securities, notes payable, current long term debt, etc). And that notes payable should be consider under net borrowing.

Great, thanks for your help. That was quite confusing.

Great, thanks for your help. That was quite confusing.

For clarity sake, Net borrowing DOES include changes in LTD and notes payable, correct?

Net borrowing do

Wc inv dont

That is correct.

I searched the internet and the following quote came out from a book “Equity Asset Valuation” written by Jerald E Pinto, CFA et al. On page 168 there is a quote that says

“Because notes payable increased by $50 million ($250 million - $200 million) and long-term debt increased by $25 million ($890 million - $865 million), net borrowing is $75 million.”

On page 169 there is another memorable quote that says

“NI = (EBIT - Int) (1 - Tax rate) = EBIT( 1 - Tax rate) - Int( 1 - Tax rate)”

and similarly a few lines further down

“NI = (EBITDA - Dep - Int) (1 - Tax rate) = EBITDA( 1 - Tax rate) - Dep( 1 - Tax rate) - Int( 1 - Tax rate)”

Plug and chug into the formulas

FCFF = NI + Int( 1 - Tax rate) + Dep - FCInv - WCInv


FCFE = FCFF - Int(1 - Tax rate) + net borrowing

That NI is EBIT minus interest rate, and then remove tax, is obvious from the name: EBIT. Similarly, for EBITDTA you deduct Interest and Depreciation/amortization, and then remove tax, to get to NI. That way the first and second formulas are easy to remember.

The authors (Pinto et al) also adds that many tedious calculations necessary to adjust when starting form NI aren’t needed when starting from EBIT or EBITDA.

On page 174 the author discusses the debt ratio, or rather the target debt ratio. Capital expenditure has two components: those to maintain existing capacity and those for growth. The trick here is to assume that any new fixed capital investment or working capital investment will be partially financed with debt according to the DR.

Assume depreciation is the only noncash charge, then

FCFE = NI + Dep - FCInv - WCInv + net borrowing {rearrange} is equal to NI + (FCInv - Dep) + WCInv + net borrowing and the term “FCInv - Dep” is the incremental fixed capital expenditure. The need to forecast net borrowing is now unnecessary thanks to rearranging and realising that part of it is financed with net borrowing according to the DR, so that part “goes away” (cancels out with net borrowing term).

Net borrowing = DR( FCInv - Dep) + DR( WCInv )

which means that if DR = 45% then 45% of new investments will be financed with debt. It also means that

FCFE = NI - (FCInv - Dep) - WCInv + [DR(FcInv - Dep) + DR (WCInv)] and now with a little algebra = NI - (1 - DR)(FCInv - Dep) - (1 - DR)( WCInv )

DR is the percentage of debt to the sum of debt and equity, so it’s D / (D + E) and not D/E (which I actually thought for a split second on a mock exam yesterday)!

Seems to be a good book maybe something to wish for as a present once we’ve cleared this level (Level II)…

so considering they are wrong, what is the FCFE for that one?

and why are they using the difference in current assets? current assets include cash which is not part of working capital?

how did anyone not notice the mistake by them including cash as networking capital? this is a huge mistake!!! and it sucks cuz i spent about 10min on this question when i was timing my self because i couldnt get the answer this is really messed up because i spent so much time on this question !! so pissed!