Chapter 4: Cash Flow and Financial Planning

The cash flow numbers used in valuations come from “depreciation”:

Depreciation is a portion of the costs of fixed assets charged against annual revenues
over time, which will reduce the income that a firm report on its income statement and will
reduce the taxes that the firm must pay. However, depreciation deductions are not associated
with any cash outlay because when a firm deducts depreciation expense, it is allocating a
portion of an asset’s original cost as a charge against that year’s income. The net effect is that
depreciation deductions increase a firm’s cash flow.
Depreciation for tax purposes is determined by using the modified accelerated cost
recovery system (MACRS) which is a system used to determine the depreciation of assets for
tax purposes.
Depreciation Methods for financial reporting purposes, companies can use straight-
line, double-declining balance, and sum-of-the-years’ digits. For tax purposes, assets in the
first four MACRS property classes are depreciated by the by the double-declining balance
method using a half-year convention (a half-year’s depreciation is taken in the year the asset
is purchased, and can switch to straight line when advantageous.
Inflows (sources) of Cash:
 Decrease in any assets
 Increase in any liability
 Net profits after taxes
 Depreciation and other mon-cash charges
 Sale of stock
Outflows (uses) of Cash:
 Increase in any asset
 Decrease in any liability
 Net loss after tax
 Dividends paid
 Repurchase or retirement of stock
Long-term (strategic) financial plans lay out a company’s planned financial actions and
the anticipated impact of those actions over periods ranging from 2 to 10 years.
Short-term (operating) financial plans specify short-term financial actions and the
anticipated impact of those actions.
 The cash budget (cash forecast) is a statement of the firm’s planned inflows and
outflows of cash that is used to estimate its short-term cash requirements.
The sales forecast is the prediction of the firm’s sales over a given period, based on
external and/or internal data; used as the key input to the short-term financial planning
purchase. External forecast is a sales forecast based on the relationships observed between
the firm’s sales and certain key external economic indicators. Internal forecast is a sales
forecast based on a build-up, or consensus, of sales forecast through the frim’s own sales
channels.