Prof.

Irene Comeig – Financial Management, GIB 2021/22

Problem 1. The importance of cash flows: Identification of cash flows

The most important job of a financial manager is to create value from the firm’s capital
budgeting, financing, and net working capital activities.

How do financial managers create value?

The answer is that the firm should:

1. Try to buy assets that generate more cash than they cost.
2. Sell financial assets (Ex. Loans, bonds, stocks and other financial
instruments) that raise more cash than they cost. (????!!!!Efficient markets?
See Unit 8)

Thus, the firm must create more cash flow than it uses.
We are interested in cash flows, not in profits.

Unfortunately, it is not easy to observe future cash flows directly. Much of the
information we obtain is in the form of accounting statements, and much of the work of
financial analysis is to extract cash flow information from accounting statements. The
following example illustrates how this is done.

Accounting Profit versus Cash Flows.

The CARD Company is willing to change its card design for the next 3 years. To
do so requires the purchase of new machinery for €10,000. The Department of Sales
estimates that production for the first year might be 55,000 units, which is expected
to grow by 20 percent per year for the next years. Given the product features and the
market competition, the selling price per unit should be €2.50 for the first year, and
it is expected to grow by the inflation rate each year.

CARD Company has estimated that the fixed costs for the project’s first year are
€100,000. Estimated first year’s variable costs are €0.50 per unit. Fixed costs are
expected to grow by the inflation rate each year. Variable costs are expected to grow
by the double of the inflation rate each year.

Assuming:
• Annual inflation rate for the next years is 4%
• The new machinery will be depreciated straight-line to €1,000 over 10 years.
• However, CARD Company will sell the machinery at the end of the third year
at €8,000, its market value.
• All production is sold, and all costs and revenues are paid in cash.

Calculate the year 0 to year 3 Income Statement and the year 0 to year 3 project
cash flows.

Calculate again the year 0 to year 3 project cash flows assuming a corporate tax
rate of 30%. Assume that taxes are paid the year incomes are generated.