cash flows - sundaram

8/14/2019 Cash Flows - Sundaram

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CASH FLOWS1

1) Introduction

The starting point for any financial decision is to assess the correct cash flows associatedwith that decision. The focus in this note is on deriving the conceptually correct cashflows for the purposes of capital budgeting and corporate valuation. The correct measureof cash flow for both purposes is the free cash flow, often just called cash flow.

There are important differences between cash flow and the notion of profit or netincome found in accounting statements. Net income is not the same as cash flow. Thereare three basic concepts to apply when deriving cash flow:

i) Inflows and outflows of funds are accounted for as cash flow only when theyactually occur;

ii)

The definition of cash flow excludes all funds flows associated with ways offinancingthe investment.i.e., cash flow reflects solely the outcome ofoperatingand investingdecisions of a project or a division or a company, notits financing decisions;

iii) Project cash flow should only consider flows that are specific to the projectunder considerationi.e., project cash flow should be derived incrementally,or as an additionto an existing set of activities in the division or the firm.

2) Two Basic Types of Cash Flow: Operating Cash Flow and Free Cash Flow

Define the following with respect to a division or a firm or a project:

Rev = RevenuesCGS = Cost of goods soldSGA = Selling, general, and administrative expendituresEBITDA = Rev CGS SGADep = Depreciation and Tax-deductible AmortizationEBIT = EBITDA DepInt = Interest ExpensesEBT = EBIT IntTax = Total cash taxes paidtc = Corporate (cash) tax rate (= Tax/EBT)NI = Net income = EBT Tax = EBT*(1 tc)Capex = Net capital expenditureNWC = Net working capital (= Curr. assets Curr. liabilities)

1 This note was developed by Anant K. Sundaram, Faculty Director of Executive Education, Tuck

School of Business at Dartmouth. 2003 (Revised 5/04).


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Also define:NIE = Unlevered net income

= (Rev CGS SGA Dep)*(1 tc)= EBIT*(1 tc)

Therefore, unlevered net income can also be written as:NIE = (EBITDA Dep)*(1 tc)

or equivalently as

NIE = NI + (1tc)*Int

Sometimes, this unlevered net income is also referred to as EBIAT (earnings beforeinterest aftertaxes), or in the context of Economic Value Added (EVA) calculations,

NOPAT (net operating profit after taxes).

Also, define !NWC as the change in net working capital. Since NWC is equal to thevalue of current assets (CA) minus the value of current liabilities (CL), then !NWC mustbe equal to !CA minus !CL (i.e., change in current assets minus change in currentliabilities). When this number is positive (i.e., !CA !CL > 0), the firm has a cashoutflow. When this number is negative (i.e., !CA !CL < 0), the firm has a cash inflow.(We will explore why this is true after we have gone through an example below).

The operating cash flow,or OCF is defined as:2OCF = NIE + Dep

= EBIT*(1 tc) + Dep= EBITDA*(1 tc) + tc*Dep= NI + (1 tc)*Int + Dep

The total cash flow or free cash flowis then defined asFCF = OCF Capex !NWC

That is, FCF takes into account not only the flows generated from the income statement,but also the net capital expenditures and net working capital changes as reflected in thebalance sheet. It considers the flows associated with operating and investing decisions.The definition ignores financing decisionsin other words, FCF is derived as though thefirm or project is unlevered.

For this reason, FCF is also called the unlevered free cash flow. When we use the termcash flow we will always mean unlevered free cash flow.

2However, in the definition below, if Amortization charges (AMORT) are nottax-deductible (unlike

Depreciation charges), then we should add back only (1 tc)*AMORT to EBIT*(1 tc) to derive OCF.


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3) An Example

Suppose a firm has $100 in revenues, $50 in cost of goods sold (CGS), and $10 in selling,general and administrative expenditures (SGA). The depreciation charges during the year

are $10, and the firm paid interest of $5 and dividends of $5. During the year, it invested$30 in new capital equipment and received $5 from sale of land. Its current assets (e.g.,inventories, receivables) went up by $10 compared to the previous year, and its currentliabilities (e.g., payables) went up by $6. The firms effective corporate tax rate is 50%.What is its: (i) Operating cash flow; (ii) Free cash flow?

Using the data and the definitions above:Rev = $ 100.0EBITDA = Rev CGS SGA = $ 40.0Dep = = $ 10.0

EBIT = EBITDA Dep = $ 30.0tc = = 50%NIE = EBIT*(1 tc) = $ 15.0EBT = EBIT Int = $ 25.0NI = EBT*(1 tc) = $ 12.5Capex (Net) = 30 5 = $ 25.0!NWC = !CA !CL = 10 6 = $ 4.0

The OCF for this firm is:NIE + Dep = EBIT*(1 tc) + Dep

= 30*(1 0.5) + 10= EBITDA*(1 tc) + tc*Dep= 40*(1 0.5) + 0.5*10= NI + Dep + (1 tc)*Int= 12.5 + 10 + 0.5*5= $25

The FCF for this firm is:OCF Capex !NWC = (25 25 4) = $ 4

In other words, this firm has positive operating cash flows, but its free cash flows arenegative. The latter is not necessarily good or badit simply means that the firm isundertaking investment activities that cannot be financed solely through internallygenerated cash flows.


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4) Whats the Intuition Behind !NWC?

Recall that a positive change in a firms net working capital is a cash outflow, and anegative change in a firms net working capital is a cash inflow. Why is this the case?

This comes from the more general idea that any increase in a firms current assets uses upcash that could have been used elsewhere, and any increase in current liabilities is asource of cash.

For example, consider the two most common items that constitute a firms current assets:inventories and receivables.

An increase in inventories means that your product is sitting (as yet unsold) in thewarehouse, while it has cost cash flow to produce. Until it gets sold and the checkactually arrives, the inventory uses up your cash flows.

With receivables, an increase means that you have more money that is owed to you.Although you have sold the product, it has not become cash flow yet. It willbecome cash flow only when the check is actually cashed.3

Similarly, consider the most common type of current liabilities: payables. An increase inyour payables means that you are able to stretch your payments out. The slower you haveto pay, the more cash you have available today for use elsewhere in the firm.

4

Typically, from year to year, some of the increases in current assets (i.e., cash outflows)are balanced out with increases in your current liabilities (i.e., cash inflows). It is thedifference between the twoi.e., !NWCthat matters.

5) Summary of Ideas in Deriving OCF and FCF

The definitions of OCF and FCFaccount for cash flows when they occur:For example,investment expenditure is taken into account when it occurs, and not over time asdepreciation as in accounting statements. (Indeed, depreciation is a cash inflow, sincemoney never left the company, but it was deducted in the income statement as though itwas a cost of doing business).

An increase in net working capital requirements is a cash outflow, and a decrease in networking capital requirements is a cash inflow.

3By logical extension, this means that an increase in cash and marketable securities is a cash outflow

which, of course, it is conceptually. However, in the context of corporate valuation, all or most of the cash is usually

assumed to be taken out, and we therefore typically focus only on non-cashcurrent assets.

4There is the question of whether short-term debt (STD) should be considered a part of the current

liabilities or whether it should be treated as a financing decision, and hence ignored for the purposes of deriving cash

flows. Often in practice, in the context of corporate valuation, STD is considered a financing decision, and we

typically focus on only non-STDcurrent liabilities.


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Note that interest expenses do not appear anywhere in the definition of cash flows(neither do dividend payments). There is a more general principle here: The definitionof cash flow excludes all the effects of financing decisions(the effect of financingdecisions are considered through the discount rate for the calculating the NPV of theproject). Cash flow is derived as though the firm is an allequity, or an unlevered firm.

For this reason, the definition of cash flow above is also sometimes referred to as theunlevered free cash flow (i.e., it is derived as though the firm has no leverage).

6) Additional Factors to Consider

There are other additional factors that must be kept in mind in deriving the correct cashflows for capital budgeting or corporate valuation purposes:

Ignore all sunk costs. A sunk cost is a cost that has already occurred and our taking onthe project (or not taking it on) will have no effect on these costs. This is consistent with

the principle of focusing only on incremental cash flows. You have to avoid thetemptation of making decisions based on considerations such as I have already spent $Xbillion on Project Y, so I must spend $Z billion more.

When you spend more based on sunk costs, you may be just throwing good money afterbad. More importantly, if you consider sunk costs in your valuation decisions, you arelikely to forego value-creating projects that you should take on.

Include all opportunity costs. An opportunity cost is the cost associated with the factthat, by taking on the project, you may be forgoing the opportunity to use that assetelsewhere. For example, suppose there is a seemingly unused machine or building orland lying around that the project will use. You should include the true market price ofthat machine or land or building in the cost of the project, whether it is currently beingused or not.

Include the costs and benefits of all side effects. This means, consider all the possiblespillover effectsof the project on the other parts of the firm. For example, it is believedthat the ability to produce commodity chips (e.g., DRAMs) provides semiconductor firmswith the manufacturing competence to produce more complex chips (e.g.,microprocessors). If that is the case, the evaluation of a commodity chip project shouldattempt to take into account the positive spillover effects of the option value associatedwith the ability to take on a more complex project (or more flexible strategies) in thefuture. (This is an example of a more general option to expand associated with takingon a project. Such options include options to expand product scope or scale, options toexpand geographic scope or scale, or options that provide operational and strategicflexibility to take on future projects.)

There are also, of course, options to abandon or shrink, which implies that the projectcan be cut off after a certain date relatively costlessly, e.g., when it begins to producenegative cash flows. In some instances, such options may not exist, or may incur a


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significant cost to exercise. An example would be the decommissioning cost that isassociated with a nuclear reactor. Thirty years down the road, we may have to incur costsin disposing the nuclear fuel and in winding down the project. Such costs should beexplicitly considered in the decision of whether to invest in the project.

Yet another common type of side effect may be the erosion associated with theintroduction of a new product that cannibalizes into the sales of an existing productwithin the firm (assuming, of course, that a competitor wouldnt take the existing salesaway anyway, through their new product introduction).

Properlyallocate all overheadsassociated with the new project. In many instancesthese overheads might be hiddenmake them explicit. In other instances, you will havethe tendency to justify projects based on assessments such as my existing sales staffhave extra time, so they can use their slack to also sell the new product. If your existingoverheads will be used in any way for the new product or project, then you should pro-rate a fair value for those costs and apply them to the new project (If you cant, then you

are carrying too much overhead in your existing business that you should probably bereducing anyway).

All of these considerations reinforce the idea that the cash flows associated with takingon any new activity should be done incrementallyi.e., in terms of all the incrementaleffects that the new project has on a set of ongoing or potential projects taken on by thefirm. This, in turn, will mean that you have to make a number of specific assumptions inthe derivation of cash flows.

7) Treatment of Inflation

Inflation is a fact of life, and must be considered in capital budgeting. The basic rule isthe following: either use real (i.e., inflation-adjusted) cash flows and real discount rates isassessing the PV of a project, or use nominal cash flows and nominal discount rates. Theidea is to be consistent in both the numerator and the denominator of your PV calculation.

The real discount rate is approximately equal to the nominal discount rate minus theexpected inflation rate.5

Often, as a matter of convenience, it is simpler to work with nominal cash flows anddiscount rates (since many cash flow items are de factonominal, and discount rates arealso usually nominal). But that also means that there may be some cash flow items forwhich you have to make explicit assumptions (and appropriate adjustments) concerninginflation rates.

5The exact formula is: If the nominal discount rate is r, the real discount rate R, and the inflation rate i,

then 1 + r= (1 + R)*(1 + i), and the real interest rate is R= [(1 + r)/(1 + i)] 1

cash flows - sundaram

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