In a scenario with switching from LIFO to FIFO in a declining steel price environment, what happens to free cash flow and enterprise value?

In a scenario with switching from LIFO to FIFO in a declining steel price environment, what happens to free cash flow and enterprise value?

• A. Free cash flow increases; enterprise value increases
• B. Free cash flow increases; enterprise value decreases
• C. Free cash flow remains unchanged; enterprise value decreases
• D. Free cash flow decreases; enterprise value decreases

Answer: (D)

Switching from LIFO to FIFO changes how costs flow through the income statement and how inventory is valued, and the direction of that change depends on the price environment. In a declining steel price environment, FIFO pushes higher older costs into cost of goods sold compared with LIFO, which uses more recent (lower) costs. That raise in COGS compresses gross margin and lowers operating income and pre-tax earnings. Even though taxes will often fall as profits shrink, the overall effect on cash generated from operations tends to be negative in the near term because the drop in earnings and the associated working-capital dynamics reduce cash from operations more than any tax shield can offset. Free cash flow, which hinges on operating cash flow minus capital expenditures, thus declines. Enterprise value, tied to the present value of those free cash flows (and the economics of the business under the new inventory method), also falls. The one-time accounting impact of changing inventory method can further weight the near-term cash flow picture, reinforcing the decline in value. In short, the heavier COGS under FIFO in a falling price setting reduces cash generation and hence lowers both free cash flow and enterprise value.

Switching from LIFO to FIFO changes how costs flow through the income statement and how inventory is valued, and the direction of that change depends on the price environment. In a declining steel price environment, FIFO pushes higher older costs into cost of goods sold compared with LIFO, which uses more recent (lower) costs. That raise in COGS compresses gross margin and lowers operating income and pre-tax earnings.

Even though taxes will often fall as profits shrink, the overall effect on cash generated from operations tends to be negative in the near term because the drop in earnings and the associated working-capital dynamics reduce cash from operations more than any tax shield can offset. Free cash flow, which hinges on operating cash flow minus capital expenditures, thus declines.

Enterprise value, tied to the present value of those free cash flows (and the economics of the business under the new inventory method), also falls. The one-time accounting impact of changing inventory method can further weight the near-term cash flow picture, reinforcing the decline in value. In short, the heavier COGS under FIFO in a falling price setting reduces cash generation and hence lowers both free cash flow and enterprise value.