BUSINESS FINANCE II

Prof. Ricardo Torrecilla, PhD

ricardo.torrecilla@euruni.edu

UNIT 2
Capital Investment Decision Analysis and Free Cashflows
1. FREE CASHFLOW DEFINITION
The free cashflow is the amount of money, real money, that a
company has yielded within one period.

And the money (not the accounting profit) the company has earned
ignoring debt flows.

Imagine that a company has generated a €216 M free cashflow in one

period. It means that that money will be in its bank accounts because
it is real cash. At the same time, the company may take out a loan
worth €20 M. Immediately, the company’s bank accounts would
increase by those €20 M. However, that incremental money wasn’t
generated by the operation of the company. Therefore, the free
cashflow tell us about the actual money a company earns by itself. In
the same vein, an indebted company will have to pay interests on the
debt. The free cashflow figure also ignores the outlays due to the
interest charge.
2. FREE CASHFLOW COMPUTATION

The formula for computing the FCF is the one below:

+ EBIT*(1-T)
+ Amortization & Depreciation
+/- ∆ Working Capital Requirements
+/- ∆ Investments in Fixed Assets
FCF

Let’s discuss one item at a time.

1. EBIT stands for Earnings Before Interests and Taxes. As we have said,
the free cashflow is the money a company has got in its coffers at a
certain period, ignoring debt flows.
However, any company must pay taxes on income. Thus, the EBIT
figure will have to be adjusted for the tax payment, because it will be an
actual disbursement.
EBIT*(1-T)
T means the tax bracket on income that the company is subject to. It is
totally dependent on the jurisdiction and it might change within the
same jurisdiction according with the dimension of the company, usually
measured by either its anual revenue figure or earnings.
Example. Company A has earned a €426 EBIT and it must pay 34% taxes
on income. Thus, tax payments will be equal to: 426*0,34 = 144,84;
And the after-tax EBIT will be 426-144,84 = 281,16; 426*(1-0,34) =
281,16
2. Amortization & Depreciation

When we draw the income statement of a company, we should subtract

amortization and depreciation charges from EBITDA (Earning Before
Interests, Taxes, Amortization & Depreciation).
A&D intend to reflect the deterioration of fixed assets over time. That
is, fixed assets are believed to have a certain useful life, according with
the criteria of the company, after which they will no longer be useful for
its purpose and will have to be replaced. What A&D charges do is to
decrease the taxable profit, thus allowing the company to save money
to replace those assets in the future.
However, those are accounting charges, not actual outlays, which
means that the money is still within the company’s bank accounts.
Therefore, when computing the free cashflow we should add the A&D
charges that had been previously subtracted.
Depreciation is meant for tangible fixed assets such as machinery,
vehicles, facilities, etc., whereas amortization is meant for intangible
assets: patents, licenses, and similar.

Normally, companies are not allowed free A&D charges. CFOs must
consult official A&D tables issued by governments on a regular basis to
assess the percentage that can be charged in the P&L statement for
taxation purposes.

Example. Company R has purchased machinery worth €5.000.000 for its

production process. Consider two different scenarios. In the first one,
authorities allowed for straight depreciation within a 10-year lifespan:
5.000.000 / 10 = 500.000. It will be the annual depreciation charge.
In the second scenario, the company wil be allowed accelerated
depreciation instead. The overall amount will be amortized within a
three-year lifespan instead of a 10-year one. 5.000.000 / 3 = 1.666.667
on an annual basis. Let’s compare the results between the two different
depreciation policies. Tax payments decrease significantly under the
second scenario

P&L Statement
Sales 15.618.424 15.618.424
COGS 8.121.580 8.121.580
Gross Margin 7.496.844 7.496.844
Personnel 3.123.685 3.123.685
Other Exploitation Expenses 312.368 312.368
EBITDA 4.060.790 4.060.790
Am.&Dep. 500.000 1.666.667
EBIT 3.560.790 2.394.124
Interests 125.000 125.000
EBT 3.435.790 2.269.124
Taxes, 40% 1.374.316 907.649
Net Income 2.061.474 1.361.474
3. Working Capital Requirements

+/- ∆ Working Capital Requirements:

(Accounts Receivable + Inventories) – Accounts Payable

It gives us an indication of how our financing needs are growing relative

to our current assets.
Normally, not all companies can cash in their sales immediately. Usually,
they grant a period to their customers before they pay for the
corresponding invoices of the items they bought. The sales that have
not been cashed in yet accrue on “accounts receivable”. By looking at
this accounting entry we will see the amount of money the company’s
current customers owe it.
The greater the amount of money within “accounts receivable”, the
greater the credit the company has granted to its customers. It is
exactly as if the company was lending money to them.
4. Inventories

Inventories also matter and matter a lot. A company must keep

inventories within certain boundaries according with its production
process to prevent unwanted interruptions from happening. An
excessive inventory level would be a waste of money. This concept will
be discussed further in chapters to come. However, we can anticipate
that too many inputs on the shelves do not generate money. On the
contrary, it is a cost.

5. Accounts Payable

Now, we are going to consider the opposite perspective relative to a

company’s sales, when a company gets inputs from its suppliers.
Normally, companies do not pay immediatley their purchases. Suppliers
grant a period, such as 30 days, 60 or even 90 days, until the company
effectively disburses the money. This is a real credit, as if it were a true
loan granted for free by the suppliers to the company.
Thus, the financing need that a company will have in the end will be the
result of the amount that needs to be funded minus the loan granted
by its suppliers:

Accounts Receivable + Inventories – Accounts Payable =

Working Capital Requirements

• An increase in WCR = The financing needs have grown more than

the credit granted by the suppliers = less cash in the company’s
bank accounts

• A decrease in WCR = the financing needs have grown less than the
credit granted by the suppliers = more cash in the company’s coffers
6. Investment in new fixed assets

Of course, it will have to be taken into account for free-cashflow

computation purposes. When a company purchases new assets, it
means a drain in its coffers, money going out from its bank accounts.
Example. Repsol, the Spanish oil company has just reported its
financials. The company has just said that its EBIT amounts to €1.637,1
M. Additionally, depreciation charges have been reported to be €18,3
M, the increase in WCR, €218,2 M, and investments in new plants
€418,4. The income tax bracket has been 32,5%. Compute Repsol’s FCF.

1.637,1*(1-0,325) = 1.105 M
+1.105 EBIT (after taxes)
+18,3 Depreciation
-218,2 Increase in WCR
-418,4 New investments
FCF = €486,7 M

Example. Starbucks’ 2020 EBIT amounted to $1.562 B (billion). Amort.

& dep. charges had been $143,2 M. WCR decreased by $214,1 M.
Investments to refurbish proprietary US outlets peaked at $418,7 M.
The effective tax bracket on income, after allowed tax deductions, had
been 29,4%. Compute the FCF.

1.562.000 * (1-0,294) = 1.102.772 M

1.102.772 EBIT (after taxes)

+143,2 Amort. & Dep.
+214,1 Decrease in WCR
-418,7 Investments in fixed assets

FCF = $1.102.711 ($1.102,7 B)

By discounting the FCF of company using the WACC as the discount
rate, we get to the value of the assets of the company (assets = equity
+ debt)
1. GUIDELINES FOR CAPITAL BUDGETING

Capital budgeting is the technique used by companies to evaluate

major investment projects. For instance. Harley Davidson Motorcycles
decided to launch a new off-road model, the Pan America, expected to
be available in the line-up on February 2021, four years ago. A new
completely different model, H-D only manufactures on-road
motorcycles, entails an entire committed R+D team, the setting of a
new production line (investment in fixed assets) and the investment in
working capital requirements according to the sales forecast.

a. Use free cashflows rather than accounting profits

Projects should be evaluated on a cashflow basis. A company, such as

H-D needs to know when it will cash money (the return from sales)
and its amount, and when it will have to pay for the production inputs
(team included) and the amount too. And this must be done on a
cashflow basis precisely to be able to forecast adequately the flows of
cash over time. Otherwise, the company may get short of money due
to a mismatch among cashflows and the project may end up in
complete failure despite being a really profitable one.
Accounting profits can be very misleading.

• The bottom line of a P&L statement only says the theoretical

amount of money a company has earned within a certain period
and according with a determined set of accounting rules. Should
the accounting rules change (and they do change over time), the
profit figure will change, while the true performance of the
company remains the same. Further, the performance of the same
company in the same period will yield different net income figures
depending on the jurisdiction.
• The bottom line says the income the company has earned but not
whether this money has been effectively cashed in.
• The immediate consequence of the above is that a company
yielding sound net profits might be in dire straits, in the verge of
defaulting due to liquidity issues, if it does not cash its sales on a
timely basis.
Example. Consider a startup, which is growing very fast, under two
different scenarios. The first one is the scenario in which the startup
cashes in its sales on a regular basis as agreed upon with its
customers. The cash account of the company seems to be OK and,
most important, the amount of accounts receivable is under control.
In the second scenario, the company neglects its collection policy and
accounts receivable skyrocket up to an astonishing proportion relative
to the other magnitudes within the current assets. Apparently, the
company seems to cope with the situation. However, if we drew the
cashflow statement, we could see that the company is facing severe
liquidity issues.
1. P&L STATEMENT
1st Year 2nd Year 3rd Year 4th Year 5th Year
Sales 236.250 354.375 531.563 1.063.125 2.126.250
COGS 82.688 124.031 186.047 372.094 744.188
Gross Margin 153.563 230.344 345.516 691.031 1.382.063
Gross Salaries 100.800 100.800 100.800 169.200 169.200
Social Costs 28.224 28.224 28.224 47.376 47.376
Rent 30.000 30.000 30.000 60.000 60.000
Supplies 10.800 11.880 13.068 19.602 21.562
Insurance 1.800 1.900 2.000 2.500 2.500
Other Expenses 18.000 23.400 28.080 42.120 46.332
EBITDA -36.062 34.140 143.344 350.233 1.035.092
Set-up-Costs Amortization 2.400 2.400 2.400 2.400 2.400
Refurbishment Depreciation 9.000 9.000 9.000 28.000 28.000
Vehicle Depreciation 5.000 5.000 5.000 17.000 17.000
Equipment Depreciation 15.000 15.000 15.000 50.800 50.800
EBIT -67.462 2.740 111.944 252.033 936.892
Interests 4.793 3.826 2.811 1.746 627
EBT -72.254 -1.086 109.132 250.288 936.265
Taxes, 25% -18.064 -272 27.283 62.572 234.066
NET PROFIT -54.191 -815 81.849 187.716 702.199
Scenario A. Collection policy under control
2. BALANCE SHEET
0 Year 1st Year 2nd Year 3rd Year 4th Year 5th Year
Cash 85.421 21.068 16.434 36.701 225.480 913.952
Accounts Receivable 19.688 29.531 44.297 88.594 177.188
Inventories 6.891 10.336 15.504 31.008 62.016 62.016
Rental deposit 5.000 5.000 5.000 10.000 10.000 10.000
Rent paid in advance 2.500 2.500 2.500 5.000 5.000 5.000
Set-up Costs 12.000 12.000 12.000 12.000 12.000 12.000
Acc. Amortization -2.400 -4.800 -7.200 -9.600 -12.000
Refurbishment 45.000 45.000 45.000 140.000 140.000 140.000
Acc. Depreciation -9.000 -18.000 -27.000 -55.000 -83.000
Vehicle 25.000 25.000 25.000 85.000 85.000 85.000
Acc. Depreciation -5.000 -10.000 -15.000 -32.000 -49.000
Equipment 75.000 75.000 75.000 254.000 254.000 254.000
Acc. Depreciation -15.000 -30.000 -45.000 -95.800 -146.600
TOTAL ASSETS 256.812 184.191 163.170 523.806 689.689 1.368.555
Accounts Payable 900 990 1.089 1.634 1.797
Debt 106.812 87.482 67.185 45.873 23.496 0
Current Profit -54.191 -815 81.849 187.716 702.199
Retained Earnings 0 -54.191 -55.005 26.844 214.559
Capital 150.000 150.000 150.000 450.000 450.000 450.000
LIABILITIES 256.812 184.191 163.170 523.806 689.689 1.368.555
Scenario A. Working Capital Requirements Variation

From the third exercise to the fourth, the financing needs have grown
up to:
(88.594 + 62.016 - 1.634) - (44.297 + 31.008 - 1.089) = €74.760

From the fourth exercise to the fifth, the financing needs have grown
up to:

(177.188 + 62.016 - 1.797) - (88.594 + 62.016 - 1634) = €88.431

Scenario B. Neglected collection policy
2. BALANCE SHEET
0 Year 1st Year 2nd Year 3rd Year 4th Year 5th Year
Cash 85.421 21.068 16.434 6.701 25.480 13.952
Accounts Receivable 19.688 29.531 74.297 288.594 977.188
Inventories 6.891 10.336 15.504 31.008 62.016 162.016
Rental deposit 5.000 5.000 5.000 10.000 10.000 10.000
Rent paid in advance 2.500 2.500 2.500 5.000 5.000 5.000
Set-up Costs 12.000 12.000 12.000 12.000 12.000 12.000
Acc. Amortization -2.400 -4.800 -7.200 -9.600 -12.000
Refurbishment 45.000 45.000 45.000 140.000 140.000 140.000
Acc. Depreciation -9.000 -18.000 -27.000 -55.000 -83.000
Vehicle 25.000 25.000 25.000 85.000 85.000 85.000
Acc. Depreciation -5.000 -10.000 -15.000 -32.000 -49.000
Equipment 75.000 75.000 75.000 254.000 254.000 254.000
Acc. Depreciation -15.000 -30.000 -45.000 -95.800 -146.600
TOTAL ASSETS 256.812 184.191 163.170 523.806 689.689 1.368.555
Accounts Payable 900 990 1.089 1.634 1.797
Debt 106.812 87.482 67.185 45.873 23.496 0
Current Profit -54.191 -815 81.849 187.716 702.199
Retained Earnings 0 -54.191 -55.005 26.844 214.559
Capital 150.000 150.000 150.000 450.000 450.000 450.000
LIABILITIES 256.812 184.191 163.170 523.806 689.689 1.368.555
Scenario B. Working Capital Requirements Variation

From the third exercise to the fourth, the financing needs have grown:

(288.594 + 62.016 - 1.634) - (74.297 + 31.008 - 1.089) = €244.760

From the fourth exercise to the fifth, the financing needs have grown:

(977.188 + 162.016 - 1.797) - (288.594 + 62.016 - 1.634) = €788.431

Notice, please, that while the net profit figures of the company remain
unaltered throughout the whole time span, the financing needs of the
company are completely different depending on the collection policy.
That’s why we need to rely on free cashflow rather than on net profit.
The good thing about managing cashflows instead of accounting
profits is that we would have noticed immediatley how the cash
position of the company had been sharply deteriorating. We will see
how in chapters to come, through the cashflow statement.

b. Think incremental

When evaluating a major investment project the cashflows that matter

are those than would not have been yielded otherwise. That is, both
positive and negative cashflows that are only the consequence of the
new project.

Example. Let’s get back to the startup whose business consists of a

catering service. The P&L statement of the business, according to the
founders’ expectations will be like this:
2. P&L STATEMENT
1st Year 2nd Year 3rd Year 4th Year 5th Year
Sales 236.250 354.375 531.563 797.344 1.196.016
COGS 82.688 124.031 186.047 279.070 418.605
Gross Margin 153.563 230.344 345.516 518.273 777.410
Gross Salaries 100.800 100.800 100.800 120.960 120.960
Social Costs 28.224 28.224 28.224 33.869 33.869
Rent 30.000 30.000 30.000 35.000 40.000
Supplies 10.800 11.880 13.068 15.682 18.818
Insurance 1.800 1.900 2.000 2.500 2.500
Other Expenses 18.000 23.400 28.080 33.696 40.435
EBITDA -36.062 34.140 143.344 276.567 520.828
Set-up-Costs Amortization 2.400 2.400 2.400 2.400 2.400
Refurbishment Depreciation 9.000 9.000 9.000 9.000 9.000
Vehicle Depreciation 5.000 5.000 5.000 5.000 5.000
Equipment Depreciation 15.000 15.000 15.000 15.000 15.000
EBIT -67.462 2.740 111.944 245.167 489.428
Interests 4.793 3.826 2.811 1.746 627
EBT -72.254 -1.086 109.132 243.421 488.801
Taxes, 25% -18.064 -272 27.283 60.855 122.200
NET PROFIT -54.191 -815 81.849 182.566 366.601
Now, suppose that the business plan had been a little bit different.
Consider that the founders were optimistic about raising either equity
or debt to fund an expansion at the end of the third year. According
with the new investment, the new Income Statement would be like
this:

2. P&L STATEMENT
1st Year 2nd Year 3rd Year 4th Year 5th Year
Sales 236.250 354.375 531.563 1.063.125 2.126.250
COGS 82.688 124.031 186.047 372.094 744.188
Gross Margin 153.563 230.344 345.516 691.031 1.382.063
Gross Salaries 100.800 100.800 100.800 169.200 169.200
Social Costs 28.224 28.224 28.224 47.376 47.376
Rent 30.000 30.000 30.000 60.000 60.000
Supplies 10.800 11.880 13.068 19.602 21.562
Insurance 1.800 1.900 2.000 2.500 2.500
Other Expenses 18.000 23.400 28.080 42.120 46.332
EBITDA -36.062 34.140 143.344 350.233 1.035.092
Set-up-Costs Amortization 2.400 2.400 2.400 2.400 2.400
Refurbishment Depreciation 9.000 9.000 9.000 28.000 28.000
Vehicle Depreciation 5.000 5.000 5.000 17.000 17.000
Equipment Depreciation 15.000 15.000 15.000 50.800 50.800
EBIT -67.462 2.740 111.944 252.033 936.892
Interests 4.793 3.826 2.811 1.746 627
EBT -72.254 -1.086 109.132 250.288 936.265
Taxes, 25% -18.064 -272 27.283 62.572 234.066
NET PROFIT -54.191 -815 81.849 187.716 702.199
Therefore, we should account just for the incremental EBIT, the EBIT
that would not have happened otherwise:

No expansion: Y3 = 111.944; Y4 = 245.167; Y5 = 489.428

Expansion: Y3 = 111.944; Y4 = 252.033; Y5 = 936.892

Incremental EBIT: Y3 = 0; Y4 = 6.866; Y5 = 447.464

c. Beware of cashflows diverted from existing products

Companys must be cautious when launching new products. Sales must

be expected to increase precisely due to the new launch, not at the
expense of already existing products within the company’s line-up.

Sales of the new item should not cannibalize the sales of other items
already on the line-up. Returning to our Harley-Davidson example,
financial planners from the Wisconsin company must make sure that
the sales of the new Pan America model will not come from the
pockets of Harley-lovers that decided to change their minds at the
sight of such a new model and purchase the new off-road bike instead
of the on-road initially wanted one. The Pan America bike has been
launched to enrol new customers on board, customers that would
have bought a BMW, a Guzzi or other brands and to widen the garage
of current Harley customers with a new acquisition.
d. Look for incidental and synergistic effects

The Pan America may also unexpectedly increase the sales of the
traditional Harleys. If a customer buys a new Pan America and the Pan
America fulfils all his/her expectations and can be compared to any
other leading brand in the market, if she or he gets the pleasure
he/she expected and even more, then, it might be that this new
satisfied customer looks with different eyes to other bikes of the
American company that had previously gone unnoticed.
e. Work in working capital requirements

As mentioned earlier, working capital requirements must be reckoned.

Further on our Harley example, the company will have to take into
account
• the inventory level it believes commensurate with the sales
forecast: parts for manufacturing the new bikes and spare parts for
repairing
• the credit it will be willing to grant to its official dealers. As H-D
sells through an official dealer network, H-D dealers are, in fact, H-
D’s customers
• the credit it will get, in turn, from the input suppliers to
manufacture the Pan America

All the above will have straighforward consequences on the free

cashflow figure yielded by the new bike.
f. Consider incremental expenses

The expected free cashflow yielded by the new Wisconsin sensation

will necessarily be the result of increased sales minus increased
expenses attached to the novelty: reenginering of already existing
production lines, dedicated R+D team, marketing efforts and some
others. Incremental expenses will also conform the result.

Discussing further our example of the catering startup, we can see the
effect in increased sales and increased expenses due to an expansion
plan implemented at the end of the third year and fully deployed
across the fourth and fifth ones.
2. P&L STATEMENT
1st Year 2nd Year 3rd Year 4th Year 5th Year
Sales 236.250 354.375 531.563 797.344 1.196.016
COGS 82.688 124.031 186.047 279.070 418.605
Gross Margin 153.563 230.344 345.516 518.273 777.410
Gross Salaries 100.800 100.800 100.800 120.960 120.960
Social Costs 28.224 28.224 28.224 33.869 33.869
Rent 30.000 30.000 30.000 35.000 40.000
Supplies 10.800 11.880 13.068 15.682 18.818
Insurance 1.800 1.900 2.000 2.500 2.500
Other Expenses 18.000 23.400 28.080 33.696 40.435
EBITDA -36.062 34.140 143.344 276.567 520.828
Set-up-Costs Amortization 2.400 2.400 2.400 2.400 2.400
Refurbishment Depreciation 9.000 9.000 9.000 9.000 9.000
Vehicle Depreciation 5.000 5.000 5.000 5.000 5.000
Equipment Depreciation 15.000 15.000 15.000 15.000 15.000
EBIT -67.462 2.740 111.944 245.167 489.428
Interests 4.793 3.826 2.811 1.746 627
EBT -72.254 -1.086 109.132 243.421 488.801
Taxes, 25% -18.064 -272 27.283 60.855 122.200
NET PROFIT -54.191 -815 81.849 182.566 366.601
2. P&L STATEMENT
1st Year 2nd Year 3rd Year 4th Year 5th Year
Sales 236.250 354.375 531.563 1.063.125 2.126.250
COGS 82.688 124.031 186.047 372.094 744.188
Gross Margin 153.563 230.344 345.516 691.031 1.382.063
Gross Salaries 100.800 100.800 100.800 169.200 169.200
Social Costs 28.224 28.224 28.224 47.376 47.376
Rent 30.000 30.000 30.000 60.000 60.000
Supplies 10.800 11.880 13.068 19.602 21.562
Insurance 1.800 1.900 2.000 2.500 2.500
Other Expenses 18.000 23.400 28.080 42.120 46.332
EBITDA -36.062 34.140 143.344 350.233 1.035.092
Set-up-Costs Amortization 2.400 2.400 2.400 2.400 2.400
Refurbishment Depreciation 9.000 9.000 9.000 28.000 28.000
Vehicle Depreciation 5.000 5.000 5.000 17.000 17.000
Equipment Depreciation 15.000 15.000 15.000 50.800 50.800
EBIT -67.462 2.740 111.944 252.033 936.892
Interests 4.793 3.826 2.811 1.746 627
EBT -72.254 -1.086 109.132 250.288 936.265
Taxes, 25% -18.064 -272 27.283 62.572 234.066
NET PROFIT -54.191 -815 81.849 187.716 702.199
g. Sunk costs are not incremental cashflows

The launch of a new vehicle is not a minor decision for any motorcycle
manufacturer regardless of its dimension. Surely, H-D made extensive
market research before making the final decision.

Consider the following. Perhaps, H-D, had made research on this in the
past, whether its customers would be happier if the brand
manufactured an off-road bike, but they decided not to engage in the
project in the end due to reasons other than the reaction of
prospective customers to the survey. However, after a few years they
believed that the time was ripe for undertaking such a venture and
finally launch the Pan America. If the case had been like this, then,
that marketing expenditure should not be accounted for as a cost of
the project because it is a sunk cost. A disbursement that happened in
the past regardless of the final decision on the future launch. It is a
matter of timing.
h. Account for opportunity costs

What else could have been done with the money required by the Pan
America investment? A completely redesign of the current line-up?
The renewal of a complete manufacturing facility? Etc. Real
investment alternatives have to be explored to see which one would
yield a higher profit for the company in the end.

i. Ignore interest payments and financing flows

The performance of an investment should be assessed ignoring the
way the project will be financed. Otherwise, results can be distorted.
 P&L Statement A B
Sales 15.618.424 15.618.424
COGS 8.121.580 8.121.580
Gross Margin 7.496.844 7.496.844
Personnel 3.123.685 3.123.685
Other Exploitation Expenses 312.368 312.368
EBITDA 4.060.790 4.060.790
Am.&Dep. 500.000 500.000
EBIT 3.560.790 3.560.790
Interests 0 250.000
EBT 3.560.790 3.310.790 -7,5%
Taxes, 40% 1.424.316 1.324.316
Net Income 2.136.474 1.986.474

The project is the same. However, scenario A considers 100% equity financing
while scenario B entails financing through a €6.250.000 loan whose interest rate
Is 4% annually. At the same time, once the company took out the loan, its bank
accounts increased by those €6.250.000 which were not generated by the
company’s operation
 Enhance Only
shareholder’s cashflows
value matter

Incremental
After-tax basis
cashflows

Ingnoring
financing
costs
a. What Goes into the Initial Outlay

The initial outlay will feature:

• All investments in fixed assets until those production inputs are

ready to perform the task they were bought for. That is, in addition
to the items themselves, their installation costs.
• The cost of the personnel attached to the project.
• Other exploitation expenses inherent in the project.
• The increase in working capital requirements.
Example. Consider the case of a company that needs to assess the
development of a new project. The outlay in fixed assets will be €200 M
and the disbursement in working capital requirements €50 M, that is, a
total €250 investment. Depreciation charges will be €40 annually.
Incremental sales resulting from the project, €215, and taxes, 35%.
Consider too the other explotation expenses as stated below:

P&L STATEMENT 0 1

Sales 215,0

COGS 90,3

Gross Margin 124,7

Other Operating Expenditure 58,1

Depreciation 40,0

EBIT 26,7
Let’s compute the free cashflow yielded by the project the first year:

P&L STATEMENT 0 1
Sales 215,0
COGS 90,3
Gross Margin 124,7
Other Operating Expenditure 58,1
Depreciation 40,0
EBIT 26,7
Taxes, 35% 9,3
EBIT after taxes 17,3
.+ Depreciation 40,0
.-∆ WCR 0,0
Free Cashflow, FCF 57,3
But one thing is missed, the initial outlay, the investment in fixed
assets plus the investment in working capital requirements: 200 + 50 =
€250 M

P&L STATEMENT 0 1
Sales 215,0
COGS 90,3
Gross Margin 124,7
Other Operating Expenditure 58,1
Depreciation 40,0
EBIT 26,7
Taxes, 35% 9,3
EBIT after taxes 17,3
.+ Depreciation 40,0
.-∆ WCR 0,0
Free Cashflow, FCF -250 57,3
b. What goes into the annual cashflows over the project’s life

Assume, now, that the project’s lifespan will be 5 years. And that the
profit and loss statement forecast will be as shown below:

P&L STATEMENT 0 1 2 3 4 5
Sales 215,0 221,5 228,1 234,9 242,0
COGS 90,3 93,0 95,8 98,7 101,6
Gross Margin 124,7 128,4 132,3 136,3 140,4
Other Operating Expenditure 58,1 59,8 61,6 63,4 65,3
Depreciation 40,0 40,0 40,0 40,0 40,0
EBIT 26,7 28,6 30,7 32,8 35,0
Taxes, 35% 9,3 10,0 10,7 11,5 12,3
EBIT after taxes 17,3 18,6 20,0 21,3 22,8
.+ Depreciation 40,0 40,0 40,0 40,0 40,0
.-∆ WCR 0,0 0,0 0,0 0,0
Free Cashflow, FCF -250 57,3 58,6 60,0 61,3 62,8
c. What goes into the terminal cashflows

Notice the highlighted in red €50 amount. It is the initial outlay in

working capital requirements. How is that that it should be added now
if it had to be subtracted at the beginning of the project’s life?

On the one hand, the project’s fixed assets will have to amortized. It
means that at the end of the project, if there had not been asset
replacements or renewals, the accounting value of the same must be
zero. They will no longer have value (from an accounting point of view).
However, the working capital requirements is money, cash, it does not
have to be amortized. Further, as the project is expected to yield
positive cashflows, the money that had to be initially used, will still be
there, precisely because of its profitability. Therefore, as the project
has been a successful one, the initial outlay in WCR now should be
added to the last cashflow.
P&L STATEMENT 0 1 2 3 4 5
Sales 215,0 221,5 228,1 234,9 242,0
COGS 90,3 93,0 95,8 98,7 101,6
Gross Margin 124,7 128,4 132,3 136,3 140,4
Other Operating Expenditure 58,1 59,8 61,6 63,4 65,3
Depreciation 40,0 40,0 40,0 40,0 40,0
EBIT 26,7 28,6 30,7 32,8 35,0
Taxes, 35% 9,3 10,0 10,7 11,5 12,3
EBIT after taxes 17,3 18,6 20,0 21,3 22,8
.+ Depreciation 40,0 40,0 40,0 40,0 40,0
.-∆ WCR 0,0 0,0 0,0 0,0 50,0
Free Cashflow, FCF -250 57,3 58,6 60,0 61,3 112,8

Therefore, the ending cashflow series of the project is:

0 1 2 3 4 5
Free Cashflow, FCF -250 57,3 58,6 60,0 61,3 112,8
Let’s find out whether the project is worth undertaking or not. Assume
that the capital structure of the company is 62% debt, whose average
cost is 7,2%, and equity, 38%, and the required return on the equity is
14,1%. The tax bracket, 35%.

The WACC of the company will be:

0,38*0,141 + 0,62*0,072*(1-0,35) = 0.0536 + 0.029 = 8.26%

+ + ++

And the IRR will be: 11.1% rounded

+ + ++
Further on our example, consider now that at the end of the life of the
project, the company can sell the fixed assets for €50,0. Those assets
were fully amortized and no longer useful according with the
company’s standards. However, they are still valuable for another
company which will use them for its own production process. Does this
affect the result of the investment? Of course, it does.
It can be considered as an incidental or synergistic effect, a windfall,
that comes from the project itself, directly. Thus, it should be taken into
account.

1. Value of the fixed assets recorded on the books – Accrued

depreciation: 200 -200 = 0. Book value of the assets = 0
2. Taxable amount due to the sale: +50 – book value = +50 -0 = +50
3. Taxes = 50*0,35 = 17,5
4. Net income from the asset sale after taxes = 50 -17,5 = 32,5
The impact will be a higher ending free cashflow (for the fifth year)

P&L STATEMENT 0 1 2 3 4 5
Sales 215,0 221,5 228,1 234,9 242,0
COGS 90,3 93,0 95,8 98,7 101,6
Gross Margin 124,7 128,4 132,3 136,3 140,4
Operating Expenditure 58,1 59,8 61,6 63,4 65,3
Depreciation 40,0 40,0 40,0 40,0 40,0
EBIT 26,7 28,6 30,7 32,8 35,0
Taxes, 35% 9,3 10,0 10,7 11,5 12,3
EBIT after taxes 17,3 18,6 20,0 21,3 22,8
.+ Depreciation 40,0 40,0 40,0 40,0 40,0
.-∆ WCR 0,0 0,0 0,0 0,0 50,0
Net Profit of Sold Assets 32,5
Free Cashflow, FCF -250 57,3 58,6 60,0 61,3 145,3
The result of the project will now be:

+ + ++

And the IRR will be: 13.7%, rounded

+ + ++
Example. Consider the case of a company that needs to assess the
development of a new project. The outlay in fixed assets will be €321 M
and the disbursement in working capital requirements €72 M, that is, a
total €393 investment. Depreciation charges will be €321/5 = 64,2
annually. Incremental sales resulting from the project and other
magnitudes as stated below:

P&L STATEMENT 0 1 2 3 4 5
Sales 420,0 462,0 508,2 559,0 614,9
COGS 197,4 217,1 238,9 262,7 289,0
Gross Margin 222,6 244,9 269,3 296,3 325,9
Oper. Expenditure 84,0 92,4 101,6 111,8 123,0
Depreciation 64,2 64,2 64,2 64,2 64,2
EBIT 74,4 88,3 103,5 120,3 138,7
Taxes, 40% 29,8 35,3 41,4 48,1 55,5
EBIT after taxes 44,6 53,0 62,1 72,2 83,2
.+ Depreciation 64,2 64,2 64,2 64,2 64,2
.-∆ WCR 0,0 0,0 0,0 0,0 72,0
Free Cashflow, FCF -393 108,8 117,2 126,3 136,4 219,4
The result of the project will be:

+ + ++
IRR: 20.6%

The NPV at 18% = 26.5

+ + ++
Consider now that another company purchases the machinery by €112
M at the end of the project. However, in this case, assume that the
machinery hadn’t been fully amortized.

• Depreciation schedule = 6 years

• Annual depreciation charge: 321/6 = 53.5
• Book value of the machinery: €321 – 5*53.5 = 53.5
• Selling price: 112
• Taxable profit: 112-53.5 = 58.5
• Taxes: 58.5*0,4 = 23.4
• Net profit: 58.5 – 23.4 = 35.1
P&L STATEMENT 0 1 2 3 4 5
Sales 420,0 462,0 508,2 559,0 614,9
COGS 197,4 217,1 238,9 262,7 289,0
Gross Margin 222,6 244,9 269,3 296,3 325,9
Oper. Expenditure 84,0 92,4 101,6 111,8 123,0
Depreciation 53,5 53,5 53,5 53,5 53,5
EBIT 85,1 99,0 114,2 131,0 149,4
Taxes, 40% 34,0 39,6 45,7 52,4 59,8
EBIT after taxes 51,1 59,4 68,5 78,6 89,7
.+ Depreciation 53,5 53,5 53,5 53,5 53,5
.-∆ WCR 0,0 0,0 0,0 0,0 72,0
Net Profit of sold assets 35,1
Free Cashflow, FCF -393 104,6 112,9 122,0 132,1 250,3
The result of the project now will be:

+ + ++
IRR: 20,74%

The NPV at 18% = 28,5

+ + ++
Example. Let’s compute the cashflows of the following company
according with its reported financials: P&L statement and balance
sheet. Now, we consider a company as a going concern, and we
compute the FCF for a series of years.
 2016 2017 2018 2019 2020
Sales 425,1 510,1 612,1 734,6 881,5
COGS 170,0 204,0 244,9 293,8 352,6
Gross margin 255,1 306,1 367,3 440,7 528,9
Personnel 127,5 153,0 183,6 220,4 264,4
Exploit. Expenses 51,0 61,2 73,5 88,1 105,8
Amort. & Deprec. 10,6 12,8 15,3 18,4 22,0
EBIT 65,9 79,1 94,9 113,9 136,6
Interests 4,3 4,7 5,2 5,7 6,3
EBT 61,6 74,4 89,7 108,2 130,4
Taxes, 40% 24,6 29,7 35,9 43,3 52,1
Net Income 37,0 44,6 53,8 64,9 78,2

2016 2017 2018 2019 2020

Cash + Near Cash Assets 12,8 38,4 58,9 95,1 118,1
Acc. Receivable 127,5 153,0 183,6 220,4 264,4
Inventories 17,0 20,4 24,5 29,4 35,3
CA 157,3 211,8 267,0 344,9 417,8
Fixed Assets 160,0 160,0 170,0 170,0 190,0
Acc. Depreciation 10,6 12,8 15,3 18,4 22,0
Net Fixed Assets 149,4 147,2 154,7 151,6 168,0
Total Assets 306,7 359,1 421,7 496,5 585,8
Acc. Payable 51,0 61,2 73,5 88,1 105,8
Debt 63,7 70,1 77,1 84,8 93,3
Current Profit 37,0 35,8 43,4 52,4 63,2
Capital + Retained Earnings 155,0 192,0 227,8 271,2 323,6
Total Liabilities 306,7 359,1 421,7 496,5 585,8

EBIT 65,9 79,1 94,9 113,9 136,6

EBIT*(1-0,4) 39,5 47,4 56,9 68,3 82,0
.+ Amort & Deprec. 10,6 12,8 15,3 18,4 22,0
. - Δ WCR 18,7 22,4 26,9 32,3
.- Investments in Fixed Assets 0,0 10,0 0,0 20,0
Free Cashflow, FCF 41,5 39,8 59,7 51,7
Example. Let’s compute the cashflows of the following company
according with its reported financials: P&L statement and balance
sheet. Now, we consider a company as a going concern, and we
compute the FCF for a series of years.
 2.010 2.011 2.012 2.013 2.014
Sales 635,73 667,52 700,89 735,94 772,73
COGS 286,08 300,38 315,40 331,17 347,73
Gross margin 349,65 367,13 385,49 404,77 425,00
Other Exploit. Exp. 286,08 300,38 315,40 331,17 347,73
Amort. & Deprec. 19,07 18,69 18,32 17,95 17,59
EBIT 44,50 48,06 51,77 55,64 59,68
Interests 7,35 6,88 8,25 8,28 8,28
EBT 37,15 41,18 43,52 47,36 51,40
Taxes 13,00 14,41 15,23 16,58 17,99
Net Income 24,15 26,77 28,29 30,79 33,41

2.010 2.011 2.012 2.013 2.014

Cash + near cash assets 21,17 22,23 23,34 24,51 25,73
Acc. Receivable 44,71 54,92 57,67 60,55 71,17
Inventories 89,17 101,60 106,68 112,02 117,62
CA 155,05 178,75 187,69 197,07 214,52
Fixed Assets 209,55 240,98 277,13 277,13 285,44
Acc. Depreciation -88,57 -107,26 -125,58 -143,53 -161,12
Total Assets 276,03 312,47 339,24 330,68 338,85
Acc. Payable 76,20 80,01 100,75 96,49 101,31
Debt 105,83 127,00 127,44 127,44 131,26
Current Profit 24,15 26,77 28,29 30,79 33,41
Capital + Retained Earnings 69,85 78,70 82,77 75,97 72,87
Total Liabilities 276,03 312,47 339,24 330,68 338,85

EBIT*(1-T); T=35% 28,93 31,24 33,65 36,17 38,79

.+ Amort&Deprec. 19,07 18,69 18,32 17,95 17,59
.-Δ WCR 18,83 -12,91 12,48 11,40
.- Investments in Fixed Assets 31,43 36,15 0,00 8,31
Free Cashfow, FCF -0,34 28,74 41,64 36,67