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All we have talk about is about the discount rate which is one pf the key
inputs necessary to calculate a project NPV.
The other key input is cash flows.
How do we measure cash flows in NPV calculations?
Are they the same as net income from the income statement?
In this video we will discuss what these cash flows are,
which we call free cash flows.
How they calculate them and if and how they are different from the net income.
While important thing about calculating NPV
is that we need only incremental cash flows from a project.
The company is already in operation generating revenues and incurring cost.
The manager is trying to decide whether to accept or reject the project.
The manager needs to know how are new project changes status quo.
NPV tells the manager as to how much a project changes Shareholder wealth.
This is why we said that we should accept positive NPV projects
as it increases shareholder wealth while we should reject negative NPV projects
as it decreases shareholder wealth.
So the focus is only on changes and hence we need only incremental cash flow.
That is how much additional investment is needed today.
How much addition sales is generated and what it will then will cost.
As part of these incremental cash flows we need to take an account of
any side effects of project may have an existing sales and costs.
We also need to account for
any opportunity cost incurred on account of the project.
We talk about these in a later video and get a detail.
Where do the cash flows come from?
Are they the same as net income?
The answer is no.
This goes back to our discussion of our recording information on financial
statements on a accrual basis.
Remember this means that revenues and costs are recorded on the income statement
as when the economic event occurs and not when the cash from the event is realized.
For example,
we will record sales made on credit as part of sales on our income statement.
They cannot make event, meaning delivery of product or service has already
taken place but payment for this product or service will take place in the future.
This is an accounting view of cash flow.
It shows profits as they are earned and not when they are realized in cash.
For NPV calculations, we need incremental cash the project generates, and
not what and when it is earned.
This means that we should exclude parts of sales and
costs from the income statement for which cash has not been received or paid as yet.
Remember, we had talked about the idea of expensing versus capitalizing,
earlier in the course.
A cost is expensed if its benefits are realized in the same period.
On the other hand,
a cost is capitalized If its benefits are realized over a number of periods.
This gave the rise to the idea of amortization and depreciation of costs.
For example a company may pay $ 100 million dollars in cash today to build
a cash today to build a plant and buy machinery, but
entire amount won't show up on the income statement as a cost.
It will be spread over its useful life as a depreciation expense.
This leads to overstating the amount of cash a company has on hand today and
understating its cash in future periods.
In summary, the net income includes some cash flows, and excludes others.
Further depreciation and amortization reduces net income,
when in fact they're not cash flows at all.
The incremental cash flows we need to calculate NPV are referred to as
free cash flows, FCF in short.
It is finance's view of cash flows It is the cash flow generated from the project's
operations and available for distribution to all suppliers of capital like banks,
bondholders, shareholders etc.
FCF capital captures in the cash flows related to business activities
or operation.
It's excludes all cash flows related to financing and investing activities.
Fo example,
we excludes how much interest that company pays on it's loan outstanding.
It also excludes investment that are not related to normal business activity.
This would excludes any income on from investments and marketable securities.
So, then how our FCF and net income related?
Are they the same?
The answer is no.
Net income makes adjustments for non-cash expenses like depreciation expenses
as well as cost not actually paid for,
which is captured by changes in accounts payable.
It also includes non-cash revenues,
which is captured by changes in accounts receivable.
Net income are just for financial related income and
cost like interest income and interest expense also.
So how do we calculate free cash flows?
You may realized that a lot of what we have said about the difference between
the FCF and net income is similar to the discussion
we had when we covered the statement of cash flows earlier.
Similar to the statement of cash flows, we can use the direct or
indirect method to calculate FCF.
Direct method is a lot more difficult to use to calculate FCF as we have to look
at the cash component of every single operations related activity.
As with the statement of cash flows,
it is easier to use indirect method to determine FCFs.
This would require us to start with the net income and then make adjustments for
cash and non-cash income and expenses, as well as for financing related cash flows.
For the statement of cashflows, we separated cashflows into those from
operating, investing and financing activities.
We started off adjusting net income by adding back depreciation expense,
adding back the interest expense, and subtracting out interest income.
We also made adjustments for operations-related current assets and
current liabilities like a new entry accounts receivable and accounts payable.
You should excluding changes to cash marketable securities and short-term
notes payable as their financing related current assets and liabilities.
Increases in current assets like a new entry and
account receivable means that casual spent but not receive do yet.
And so the increases need to be subtracted from net income.
On the other hand decreases in current assets will be added to net income.
We did the opposite for current liabilities.
Increases were added, and decreases were subtracted.
After all these adjustments to net income, we got cash flows from operations.
All these adjustments also apply to FCF calculations.
To arrive at the FCF, we need to subtract the cost of acquiring any fixed assets,
like plan, property, and equipment.
And also, add an income from the disposable of old fixed assets.
After these adjustments, we are able to FCF for
each year of the projects useful life.
At this point, it would be useful for you to re-look the videos on cash flows from
operating activities and that on cash flow from investing activity.
Remember, we do not care about cash flows from financing activities
as they're excluded for FCF calculation.
In summary, here's how you would calculate FCF from that income.
Add entire depreciation and
amortization expense back to net income which are non-cash costs.
Next, make adjustment for changes in operations related current asset and
liabilities.
This will include largely only changing in inventory account receivable and
account payable.
Subtract increases in current asset and decreases in current liabilities, and
add decreases in current asset and increases is in the current liabilities.
Next, subtract the cost of any fixed asset acquired during the year and
add any income from disposal of fixed assets.
Finally, add the the after tax interest expense and
subtract any after tax interest income.
After tax means multiplying the corresponding numbers by
one minus the tax rate.
After all these adjustments to net income, we have done FCFs.
Next time we will look at some other relevant cash flows that affect FCF.
But are not captured in the income statement.
These largely include side effects as well as opportunity cost.
We will also briefly discuss the idea of sunk costs and
why those are irrelevant cash flows.
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Ramabhadran ThirumalaiAssistant Professor
