Estimating Cash Flows

Aravind Sampath
November 4, 2022

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 Outline
Recap
Principles in CF estimation
Activities that impact/do not impact CF
Adjusting for depreciation
Adjusting for Net Working Capital
Adjusting for Capital Expenditure
Adjusting for Salvage Value
Adjusting for recovery of NWC
Nominal and Real rates
Concluding Remarks
Estimating FCF

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 Learning Objectives

• Estimating cash flows for capital budgeting and valuation

Reference Textbook Chapter: Ch 6

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Recap
 Recap

• First Principles - Investments need to generate | 1 more than cost involved in

doing business.
• Capital budgeting methods - tools to evaluate first principles.
• NPV - benefits of investments net cost of investment accounting for TVOM.
• NPV requires cash flows both in and out, and the discounting rate.
• So far, we assumed the data on cash flows and discounting rates are given.
• In this module, objective is to estimate the cash flows for the NPV problem.

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Principles in CF estimation
 Basic principles on cash flow estimation

• Incremental cash flow = CF generated by firm with the project minus CF

generated by firm without the project.
• Only consider CF that impact a project.
• It may also make sense to split CF into CF from operations, CF from investing,
CF from financing.
• In CF estimation, it is always over a period.
• Important: Only after-tax CF must be considered in analysis.
• Free Cash Flow - common terminology used for denoting the CF generated by a
project in a period.

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Activities that impact/do not
impact CF
 Which activities impact a project’s CF

• Non cash items: mainly depreciation and ammortization. These are not ”real”
cash costs, rather accounting costs, therefore, actual cash balance would be
higher and needs to be accordingly adjusted.
• Activities that relate to application of cash result in cash outflow - these activities
could be related to operations (working capital) or investing (capex).
• Application of cash - occurs when firm buys assets resulting in assets going up and
cash coming down. Such assets could be short term (operations) or long term
(investing).
• Cash flows related to financing would be adjusted in the discounting rate, therefore,
at this stage we ignore all CF related to financing activities

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 Which activities do not impact a project’s CF

• Sunk costs - costs a firm incurs regardless of whether a project is accepted or not.
• e.g. paying money to a consulting firm for market research.

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 Other activities that may impact a project’s CF

• Opportunity costs - costs a firm incurs because of lost CF due to alternative usage
of asset.
• e.g. firm not selling an empty warehouse intended for sale, but using it for a new
project.
• Side effects - Erosion/Synergy
• e.g. Samsung launching a new mid-range phone every other quarter.
• Allocated Costs - One expenditure benefiting multiple projects.

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Adjusting for depreciation
 Estimating Cash Flow
Adjusting for Depreciation

• Depreciation - not a ”real” cost.

• Pure ”accounting” cost suggesting how much value of a fixed asset has eroded in
the period.
• Depreciation Expense - can be found in income statement that outlines the cost.
• Impact on profit/loss - reduces taxable income and accounting profits.
• In reality - cash is higher.

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 Estimating Cash Flow
Adjusting for Depreciation

Sales 1000
Cost 400
EBITDA 600
Depreciation Expense 150
EBT 450
Tax 90
EAT/NI 360

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 Estimating Cash Flow
Adjusting for Depreciation

• What if we compute P/L assuming firm had no depreciation expense?

Item With Depreciation Without Depreciation
Sales 1000 1000
Cost 400 400
EBITDA 600 600
Depreciation Expense 150 0
EBT 450 600
Tax 90 120
EAT/NI 360 480
• Spot the difference 11/23
 Estimating Cash Flow
Adjusting for Depreciation

• At the outset, it seems that without depreciation, the accounting profits are
significantly higher (| 480 vs | 360)
• However, a deeper dive tells a different story - what if we compare P/L with
actual cash transactions?
Item P/L Cash Transactions

Sales 1000 1000

Cost 400 400

EBITDA 600

Depreciation Expense 150

EBT 450

Tax 90 90

EAT/NI 360 510

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 Estimating Cash Flow
Adjusting for Depreciation

• It seems, though accounting profit is | 360, actual cash in hand is | 510.

• This is the impact of depreciation - it purely serves as an accounting purpose, but in reality, firm’s cash
balance is higher i.e. 510 = 360 + 150.
• Actual CF = NI + Depreciation Expense.
• Alternatively, compare the previous slide - if there was no depreciation then the NI is | 480, but as there is
no depreciation, its CF is also | 480.
• However, when there is depreciation, the CF is | 510, which is | 30 more than | 480.
• This extra | 30 can be thought of as money saved in tax bill due to depreciation expense.
• If no depreciation expense, taxable income 600 instead of 450, therefore, final tax bill is 120 instead of 90
- the extra 30 saved by not paying taxes is extra cash with the firm - this | 30 saved by not paying tax is
called Depreciation Tax Shield (DTS).

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 Estimating Cash Flow
Adjusting for Depreciation

• Adjustment for Depreciation can either be top down or bottom up.

• Top Down - start with post tax EBITDA i.e. firm’s profits without depreciation
and separately add the impact of depreciation on the CF which in this case is the
DTS.
• Adjustment to CF = EBITDA × (1 − tax rate) + Depreciation Expense × tax rate
• Bottom Up - start with NI i.e. post tax profits with depreciation and add the
impact of depreciation on the CF which in this case is the entire Depreciation
Expense.
• Adjustment to CF = NI + Depreciation Expense
• In the previous e.g. CF = 510 = (480 + 150 × 0.2) or (360 + 150)

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Adjusting for Net Working Capital
 Estimating Cash Flow
Adjusting for Net Working Capital

• Net Working Capital is a core operating activity of a firm.

• Net Working Capital = Current Assets - Current Liabilities
• Investments in NWC i.e. an increase in NWC is an application (use) of cash, and would therefore reduce
cash.
• NWC is the CF that firm needs to run day-to-day operations.
• Current Assets - inventory, accounts receivables, prepaid expenses, cash etc.
• Increase in CA means firm is spending cash to buy assets, thus reducing overall CF.
• Current Liabilities - accounts payable, short term debt, notes payable, current maturities of long-term
debt etc.
• Increase in CL implies firm has generated CF.
• Therefore, an increase in NWC signals firm has spent more cash on assets than cash it received, so impact
on overall CF is negative.
• Conversely, decrease in NWC means firm has a cash excess due to reduced investment in CA while
increased cash due to CL, thus impact on overall CF is positive.

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 Estimating Cash Flow
Adjusting for Net Working Capital

• Small recap - in context of CF estimation, it is always during a period i.e. two

points in time.
• NWC is a balance sheet item, which is estimated at one point in time.
• When CF is estimated in a period, the adjustment for NWC has to be for the
NWC in the same period.
• Therefore, change in NWC is the appropriate metric than absolute NWC.
• e.g. if CF for one year is being estimated, the impact of NWC would be the
impact of the firm’s CA and CL in that particular year - this can be estimated by
looking at the difference b/w NWC from current year to previous year, called
change in NWC.

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 Estimating Cash Flow
Adjusting for Net Working Capital

• Suppose at end of FY 2020, a firm had CA of | 300 and CL of | 150, then its
NWC in 2020 is | 150.
• Suppose at end of FY 2021, the CA is | 500 while CL is | 300, then NWC in 2021
is | 200.
• In the year 2020-21, the firm invested | 200 in CA while its CL increased by | 150
i.e. the firm spent | 50 more than the cash it earned, therefore, overall its cash
reduced by | 50.
• This | 50 reduction is captured by the NWC change which changed from | 150 in
FY 20 to | 200 in FY 21.
• Therefore, the impact of NWC on CF can be captured by change in NWC.
• Adjustments to CF = NI − change in NWC
• Where change in NWC = NWCt − NWCt−1
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Adjusting for Capital Expenditure
 Estimating Cash Flow
Adjusting for Capital Expenditure

• While NWC was investing in short term assets regarding operating activities,
capital expenditures are investments firms make over long term regarding
investing activities.
• Therefore, for any particular period, all investments in capex have a negative
impact on CF as investing is a usage of cash.
• Adjustment to CF = NI - capex

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Adjusting for Salvage Value
 Estimating Cash Flow
Adjusting for Salvage Value

• Salvage value - when firm no longer uses an asset, but can fetch a price in the
market, the price/value the asset fetches upon sale is called salvage/liquidation
value.
• Any capital gains from selling an asset would incur a capital gains tax.
• Recap that all CF used for valuation must be after tax CF, therefore, we must
adjust for taxes here.
• e.g. An asset has a book value of | 1000, but was sold for | 1200. If tax rate is
10%, the firm incurs a 10% tax on the gains which is 1200-1000 = 200. Thus,
final cash firm receives on selling asset is 1200 − 200 × 10% = | 1180.
• After tax cash flow due to asset sale =
Sale price of asset − (capital gain × tax rate)

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Adjusting for recovery of NWC
 Estimating Cash Flow
Adjusting for recovery of NWC

• When firms invest in NWC each year - they’re buying inventory or increasing
credit sales or increasing credit costs or raising short term debt.
• The net effect of investments in CA and cash increase via CL has a negative
(positive) impact on CF if change in NWC is positive (negative).
• However, when a project finishes, the overall NWC investments/deficit has to be
accounted for.
• For e.g. suppose a firm made credit sale to the tune of | 1000 this period, it means someone
bought the goods/services and would be paying later. Assuming rest of NWC components do not
change, this results in an increase in NWC by | 1000. This credit has to be recovered i.e. the firm
has to receive the cash from the customers who bought on credit in the future. At this juncture, we
assume this happens at the end of the project.

• Therefore, at the end of the project, all investments/deficits in NWC has to be

aggregated and added/subtracted.
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Nominal and Real rates
 Revisiting nominal and real rates

• Whenever cash flows are nominal in nature, the discounting rate must be the
nominal rate.
• Whenever cash flows are real, the discounting rate must be the real rate.
• Recall Fischer’s equation: (1 + Rn ) = (1 + Rr ) × (1 + Ri ) where n is nominal, r is
real and i is inflation.

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Concluding Remarks
 Concluding Remarks

• To estimate a project’s cash flows, it is essential to remember that net income is not cash - this is the
starting point.
• To arrive at cash flow from net income, adjustments have to be done for depreciation, net working capital
and capital expenditure.

• It is also useful to know that any project’s timeline can be divided into three.
1. Initial Cash Flow - list of cash flows that occur at the beginning of the project at period t = 0. This
normally includes investment cost, opportunity costs, and on occasion an immediate investment in
NWC.
2. Period Cash Flow - cash flows that occur at all periods barring the beginning and end of project.
Typically includes Net Income, Depreciation, NWC and Capex.
3. Terminal Cash Flow - cash flows that occur at the end/closure of a project. Includes all cash flows
from period cash flow, plus salvage value of investment and recovery of NWC
• Note: The previous points are a general guideline, in some cases for e.g., asset sale can occur in the
middle of a project. It is essential to identify what are the CF that occur at any particular period from 0
till project end to estimate accurately.
• Do not forget to discount nominal cash flows with nominal rates and real cash flows with real rates.

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Estimating FCF
 Summing it all up

Free Cash Flow = Net Income + Depreciation Expense − change in NWC − capex

Free Cash Flow =

EBITDA × (1 − tax rate) + Depreciation Expense × tax rate − change in NWC − capex

Final Note: At project beginning and at termination, the relevant CF have to be

adjusted for (opportunity cost, after tax salvage value of asset, recovery of NWC etc.)

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