Cash Flow Analysis

There is an old saying in Finance: Cash, not profit is king. Cash flow analysis deals with the timing and amount of cash inflows/outflows from a firm or an investment

 General Overview Types of Analysis Cash Flows in Capital Budgeting Comprehensive Example

Profits and cash flows are very different things Profits under the accounting system are calculated on accrual basis rather than cash basis

 As an investor much better to look at both Income Statement and the Statement of Cash Flows As management, very important to analyze the different types of inflows/outflows for capital budgeting decisions

 Statement of CF Analysis Free Cash Flows Payback Period Net Present Value Internal Rate of Return

 Cash Flow from Operating Activities

Cash Flow from Investing Activities Cash Flow from Financing Activities

Operating Income (Earning before interest and taxes) +Depreciation = EBITDA (Earnings before interest, taxes, Depreciation, and amortization)

- cash tax payments

= after-tax cash flows from operations

 A portion of the costs of fixed assets charged against annual revenues over time. Depreciable life: Time period over which an asset is depreciated. Depreciation Methods: a) Straight-line method b) Double-declining balance c) Sum-of-the-years-digits

 Book value represents the remaining, capital investment (not yet depreciated) on the books after the total amount of depreciation charges (to date) have been subtracted from the basis. The book value (BV) is usually determined at the end of each year. Market Value (MV) is the amount realized from sale on the open market. Salvage Value (S) is the estimated trade-in value or market value at the end the assets useful life.

 First Cost or Unadjusted Basis (B) Initial purchase price + all costs incurred in placing

Important Terms

the asset in service Recovery Period (n) Depreciable life of the asset in question often set by law Depreciation Rate (dt) The fraction of the first cost removed by depreciation each year Personal Property All property except real estate used in the pursuit of profit or gain Real Property Real estate and improvements, buildings and certain structures
Land is Real Property, but by law is NOT depreciable for tax purposes

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a)Straight-line method
Original Cost Salvage Value * (1/life) * (#/12)

b)Double-declining balance
Depreciation Base * (2 * 100% / Useful Life of Asset in Years)

c) Sum-of-the-years-digits

Visionary Corporation acquired a computer set amounting $5,000 computer with a $200 salvage value and an estimated useful life of three years.
Calculate the depreciation using: a) Straight line b) Double-declining balance c) Sum-of-the-years digits

 A criteria used in capital budgeting. Defined as the number of years required to recover initial cash investment

Initial Investment in project Cash inflows after-tax Year 1 85,000.00 Year 2 90,000.00 Year 3 60,000.00 Year 4 50,000.00 Year 5 50,000.00 Payback 3.3

250,000.00 Payback 165,000.00 75,000.00 15,000.00 0 1 1 1 0.3

It will take 3 years to recover 235,000 and the .3 of the 4th year to recover the remaining 15,000. Therefore the payback in this example is 3.3.

 In simple terms NPV is the sum of discounted cash inflows from a project- the projects initial outlay If NPV is > 0 accept else reject

Net Present Value Approach

Stars Stadium is considering purchasing vending machines with a 5-year life and salvage value of P50,000. Cost of Capital is 15%.
Cost and revenue information Cost of vending machines Revenue Cost of goods sold Gross profit Cash operating costs 33,500 Depreciation 140,000 Pretax income Income tax After-tax income
750,000 843,750 506,250 337,500 173,500 164,000 64,000 100,000

(P750,000 - P50,000) 5 years

 Discount rate that equates the present value of inflows with the present value of outflows. In simple terms it reflects the rate of return for a project

 Assuming that a hospital has the opportunity to invest P205,570.50 in a new ultrasound system that will produce net cash inflows of P50,000 at the end of each of the next six years. Required: Calculate the IRR for the ultrasound system.

Formula: df=I/CF df = 205,570.50 / 50,000 = 4.11141 (refer to the PVIFA Table) Therefore: IRR = 12%

 Capital budgeting is the decision making process through which firms decide which projects get the funding Financial plans for most firms are based on the capital budgeting analysis using cash flows

 Use Free Cash Flows Rather than accounting Profits Only worry about incremental Cash Flows Cash Flow diversion from other Product Categories

 Look for Incidental or Synergistic Effects Working-Capital Requirements Incremental Expenses Opportunity Costs

Cost of new plant and Equipment Other Costs Total Cost Total Unit Sales

9,700,000.00 300,000.00 10,000,000.00 Year 1.00 2.00 3.00 4.00 5.00 Sold 50,000.00 100,000.00 100,000.00 70,000.00 50,000.00

Sales price per unit Variable cost Fixed Costs Required Working Capital Depreciation

150.00 80.00 500,000.00 100,000.00 2,000,000.00

We just added the total cost of plant with other costs and divided it by 5 years to get a straight line decpreciation.

This example is something similar to what many firms would deal with in the real world. We will first derive Free Cash Flows and then apply the NPV and IRR techniques that we learned earlier.

STEP 1 Year Units Sold Sale Price Sales Revenue Less: Variable Costs Less: Fixed Costs EBDIT Less: Depreciation EBIT Taxes (@ 34%) 0

EBIT, TAXES and DEPRECIATION are calculated here 1 2 3 4 50,000.00 100,000.00 100,000.00 70,000.00 150.00 150.00 150.00 150.00 7,500,000.00 15,000,000.00 15,000,000.00 10,500,000.00 4,000,000.00 8,000,000.00 8,000,000.00 5,600,000.00 500,000.00 500,000.00 500,000.00 500,000.00 3,000,000.00 6,500,000.00 6,500,000.00 4,400,000.00 2,000,000.00 2,000,000.00 2,000,000.00 2,000,000.00 1,000,000.00 4,500,000.00 4,500,000.00 2,400,000.00 340,000.00 1,530,000.00 1,530,000.00 816,000.00 5 50,000.00 150.00 7,500,000.00 4,000,000.00 500,000.00 3,000,000.00 2,000,000.00 1,000,000.00 340,000.00

In this example we've calculated EBIT along with taxes that we will use to derive Operating Cash Flow on the next slide. We subtract depreciation here so we can pay less taxes. The depreciation will be added back in the next step as it is a non-cash item.

STEP 2 Year EBIT Minus: Taxes Plus:Depreciation Operating Cash Flows 0

Operating Cash Flows 1 1,000,000.00 340,000.00 2,000,000.00 2,660,000.00 2 4,500,000.00 1,530,000.00 2,000,000.00 4,970,000.00 3 4 5 4,500,000.00 2,400,000.00 1,000,000.00 1,530,000.00 816,000.00 340,000.00 2,000,000.00 2,000,000.00 2,000,000.00 4,970,000.00 3,584,000.00 2,660,000.00

Depreciation is added back here as we move toward Free cash flows. Here Operating Cash Flows are derived.

STEP 3 Year

Working Capital Needs 0 1 (100,000.00) 2 3 4 5 100,000.00

In this example we have an initial outflow of working capital that is recouped completely in the last year at the termination of the project. So in year one we subtract it and add it back in year 5.

STEP 4 Year Operating Cash Flow Less: Net working capital Less: Initial Outlay Free Cash Flow 0 (100,000.00) (10,000,000.00) (10,100,000.00)

Free Cash Flow 1 2,660,000.00 2 4,970,000.00 3 4,970,000.00 4 3,584,000.00 5 2,660,000.00 100,000.00

2,660,000.00

4,970,000.00

4,970,000.00

3,584,000.00

2,760,000.00

Finally we have the free cash flows that we can use in our NPV and IRR calculations.

Now, using the date calculate the NPV and the IRR for the Project Initial Outlay Cash inflows/Year (10,100,000.00) 0

1 2,660,000.00

2 3 4,970,000.00 4,970,000.00

4 3,584,000.00

5 2,760,000.00

Depending on the answer also recommend if the project should be accepted.

Year Not Discounted Discounted Initial Outlay Required Rate

1 2,660,000.00 2,418,181.82

2 4,970,000.00 4,107,438.02

3 4,970,000.00 3,734,034.56

4 3,584,000.00 2,447,920.22

5 2,760,000.00 1,713,742.85

(10,100,000.00) 10.00% This rate depends on the firms required rate of return. Its dependent on different factors which we can't get into in this presentation. But most firms do have a given required rate of return for their projects.

NPV

4,321,317.47 Several ways to do so, first you can get the discounted cashflows for each year and then add all of them up along with the initial outlay. A simple way is to use the NPV function in excel. This is positive so we should go ahead with the project.

Year 0 1 2 3 4 5 Not Discounted (10,100,000.00) 2,660,000.00 4,970,000.00 4,970,000.00 3,584,000.00 2,760,000.00 IRR 26% Note that IRR is best solved for with a financial calculator or using a spreadsheet program. Here the excel function for IRR was used to come up with this value.