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s associated with that decision. The focus in this note is on deriving the conceptually correct cash flows for the purposes of capital budgeting and corporate valuation. The correct measure of 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 net income found in accounting statements. Net income is not the same as cash flow. There are three basic concepts to apply when deriving cash flow: i) ii) Inflows and outflows of funds are accounted for as cash flow only when they actually occur; The definition of cash flow excludes all funds flows associated with ways of financing the investment.i.e., cash flow reflects solely the outcome of operating and investing decisions of a project or a division or a company, not its financing decisions; Project cash flow should only consider flows that are specific to the project under considerationi.e., project cash flow should be derived incrementally, or as an addition to an existing set of activities in the division or the firm.

iii)

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 CGS SGA EBITDA Dep EBIT Int EBT Tax tc NI Capex NWC = = = = = = = = = = = = = Revenues Cost of goods sold Selling, general, and administrative expenditures Rev CGS SGA Depreciation and Tax-deductible Amortization EBITDA Dep Interest Expenses EBIT Int Total cash taxes paid Corporate (cash) tax rate (= Tax/EBT) Net income = EBT Tax = EBT*(1 tc) Net capital expenditure Net working capital (= Curr. assets Curr. liabilities)

This note was developed by Anant K. Sundaram, Faculty Director of Executive Education, Tuck School of Business at Dartmouth. 2003 (Revised 5/04).

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 or equivalently as NIE = NI + (1tc)*Int = (EBITDA Dep)*(1 tc)

Sometimes, this unlevered net income is also referred to as EBIAT (earnings before interest after taxes), 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 the value of current assets (CA) minus the value of current liabilities (CL), then !NWC must be equal to !CA minus !CL (i.e., change in current assets minus change in current liabilities). When this number is positive (i.e., !CA !CL > 0), the firm has a cash outflow. 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:2 OCF = = = = NIE + Dep EBIT*(1 tc) + Dep EBITDA*(1 tc) + tc*Dep NI + (1 tc)*Int + Dep

The total cash flow or free cash flow is then defined as FCF = 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 the balance sheet. It considers the flows associated with operating and investing decisions. The definition ignores financing decisionsin other words, FCF is derived as though the firm or project is unlevered. For this reason, FCF is also called the unlevered free cash flow. When we use the term cash flow we will always mean unlevered free cash flow.

2

However, in the definition below, if Amortization charges (AMORT) are not tax-deductible (unlike Depreciation charges), then we should add back only (1 tc)*AMORT to EBIT*(1 tc) to derive OCF.

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 current liabilities (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 EBITDA Dep EBIT tc NIE EBT NI Capex (Net) !NWC 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 = = = = = = = = = = Rev CGS SGA = = EBITDA Dep = = EBIT*(1 tc) = EBIT Int = EBT*(1 tc) = 30 5 = !CA !CL = 10 6 = $ 100.0 $ 40.0 $ 10.0 $ 30.0 50% $ 15.0 $ 25.0 $ 12.5 $ 25.0 $ 4.0

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 are negative. The latter is not necessarily good or badit simply means that the firm is undertaking investment activities that cannot be financed solely through internally generated cash flows.

4) Whats the Intuition Behind !NWC? Recall that a positive change in a firms net working capital is a cash outflow, and a negative 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 up cash that could have been used elsewhere, and any increase in current liabilities is a source 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 the warehouse, while it has cost cash flow to produce. Until it gets sold and the check actually 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 will become cash flow only when the check is actually cashed. 3

Similarly, consider the most common type of current liabilities: payables. An increase in your payables means that you are able to stretch your payments out. The slower you have to 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 the difference between the twoi.e., !NWCthat matters. 5) Summary of Ideas in Deriving OCF and FCF

The definitions of OCF and FCF account for cash flows when they occur: For example, investment expenditure is taken into account when it occurs, and not over time as depreciation as in accounting statements. (Indeed, depreciation is a cash inflow, since money never left the company, but it was deducted in the income statement as though it was a cost of doing business). An increase in net working capital requirements is a cash outflow, and a decrease in net working capital requirements is a cash inflow.

3

By 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-cash current assets. There 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-STD current liabilities.

4

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 definition of cash flow excludes all the effects of financing decisions (the effect of financing decisions are considered through the discount rate for the calculating the NPV of the project). 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 the unlevered 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 cash flows for capital budgeting or corporate valuation purposes: Ignore all sunk costs. A sunk cost is a cost that has already occurred and our taking on the 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 the temptation of making decisions based on considerations such as I have already spent $X billion 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 after bad. More importantly, if you consider sunk costs in your valuation decisions, you are likely to forego value-creating projects that you should take on. Include all opportunity costs. An opportunity cost is the cost associated with the fact that, by taking on the project, you may be forgoing the opportunity to use that asset elsewhere. For example, suppose there is a seemingly unused machine or building or land lying around that the project will use. You should include the true market price of that machine or land or building in the cost of the project, whether it is currently being used or not. Include the costs and benefits of all side effects. This means, consider all the possible spillover effects of the project on the other parts of the firm. For example, it is believed that the ability to produce commodity chips (e.g., DRAMs) provides semiconductor firms with the manufacturing competence to produce more complex chips (e.g., microprocessors). If that is the case, the evaluation of a commodity chip project should attempt to take into account the positive spillover effects of the option value associated with the ability to take on a more complex project (or more flexible strategies) in the future. (This is an example of a more general option to expand associated with taking on a project. Such options include options to expand product scope or scale, options to expand geographic scope or scale, or options that provide operational and strategic flexibility to take on future projects.) There are also, of course, options to abandon or shrink, which implies that the project can be cut off after a certain date relatively costlessly, e.g., when it begins to produce negative cash flows. In some instances, such options may not exist, or may incur a

significant cost to exercise. An example would be the decommissioning cost that is associated with a nuclear reactor. Thirty years down the road, we may have to incur costs in disposing the nuclear fuel and in winding down the project. Such costs should be explicitly considered in the decision of whether to invest in the project. Yet another common type of side effect may be the erosion associated with the introduction of a new product that cannibalizes into the sales of an existing product within the firm (assuming, of course, that a competitor wouldnt take the existing sales away anyway, through their new product introduction). Properly allocate all overheads associated with the new project. In many instances these overheads might be hiddenmake them explicit. In other instances, you will have the tendency to justify projects based on assessments such as my existing sales staff have extra time, so they can use their slack to also sell the new product. If your existing overheads will be used in any way for the new product or project, then you should prorate 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 be reducing anyway). All of these considerations reinforce the idea that the cash flows associated with taking on any new activity should be done incrementallyi.e., in terms of all the incremental effects that the new project has on a set of ongoing or potential projects taken on by the firm. This, in turn, will mean that you have to make a number of specific assumptions in the derivation of cash flows. 7) Treatment of Inflation Inflation is a fact of life, and must be considered in capital budgeting. The basic rule is the following: either use real (i.e., inflation-adjusted) cash flows and real discount rates is assessing the PV of a project, or use nominal cash flows and nominal discount rates. The idea 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 the expected inflation rate.5 Often, as a matter of convenience, it is simpler to work with nominal cash flows and discount rates (since many cash flow items are de facto nominal, and discount rates are also usually nominal). But that also means that there may be some cash flow items for which you have to make explicit assumptions (and appropriate adjustments) concerning inflation rates.

The 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

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