Cash Flow Analysis

What is Cash flow analysis?

Cash flow analysis deals with the timing and amount of cash inflows/outflows from a firm or an investment

Where do we start?
General Overview Types of Analysis Cash Flows in Capital Budgeting Comprehensive Example

Why Cash Flow Analysis?

Overview

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

Analysis

Budgeting

Example

Why Cash Flow Analysis?

Overview

Analysis

Budgeting

Example

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

Types of Analysis
Overview

Analysis

Budgeting

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

Example

Statement of CF Analysis
Overview

Cash Flow from Operating Activities Cash Flow from Investing Activities Cash Flow from Financing Activities

Analysis

Budgeting

Example

Free Cash Flows

Overview
Operating Income (Earning before interest and taxes)

Analysis

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

Budgeting
-cash tax payments = after-tax cash flows from operations

Example

Payback Period
Overview

Analysis

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

Budgeting

Example

Payback Period: Example

Overview
Initial Investment in project Cash inflows after -tax 1000 1000 5000 4000 5000 3.3 10000 Year 1 Year 2 Year 3 Year 4 Year 5 Payback

Analysis

Budgeting

Example

It will take 3 years to recover 7000 and the .3 of the 4th year to recover the remaining 3000. Therefore the payback in this example is 3.3.

Net Present Value

Overview

Analysis

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

Budgeting

Example

NPV: Example
Overview
Initial Outlay Required Rate Year 1 Inflow Year 2 Inflow Year 3 Inflow Year 4 Inflow Year 5 Inflow Sum NPV -30000 12% Not Discounted 10000 15000 12000 10000 11000 58000 $16,489.00 Discounted $13,392.86 $11,957.91 $8,541.36 $6,355.18 $6,241.70 $46,489.00

Analysis

Budgeting

We take the sum of the discounted values and subtract the initial outlay.

Example

Internal Rate of Return

Overview

Analysis

Budgeting

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

Example

IRR: Example
Overview
Initial Outlay Year 1 Cash Inflow Year 2 Cash Inflow Year 3 Cash Inflow -3817 1000 2000 3000 Excel has a very handy function that calculates the IRR. Make sure you enter the whole range of values including the initial outlay, which is entered as a negative value.

Analysis

Budgeting
IRR 22%

Example

What is Capital Budgeting?

Overview

Analysis

Budgeting

Example

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

CF Guidelines in Capital Budgeting

Overview

Analysis

Budgeting

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

Example

Capital Budgeting Guidelines

Overview

Analysis

Budgeting

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

Example

Comprehensive Example
Overview
Cost of new plant and Equipment Other Costs Total Cost Total Unit Sales 9,700,000 300,000 10,000,000 Year 1 2 3 4 5 150 80 500000 100000 2,000,000 Sold 50,000 100,000 100,000 70,000 50,000

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

Budgeting

Example

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.

Comprehensive Example
Overview
STEP 1 Year Units Sold Sale Price Sales Revenue Less: Variable Costs Less: Fixed Costs EBDIT Less: Depreciation EBIT Taxes (@ 34%) EBIT, TAXES and DEPRECIATION are calculated here 0 1 50,000 150 7500000 4000000 500000 3000000 2,000,000 1,000,000 340000 2 100,000 150 15000000 8000000 500000 6500000 2,000,000 4,500,000 1530000 3 100,000 150 15000000 8000000 500000 6500000 2,000,000 4,500,000 1530000 4 70,000 150 10500000 5600000 500000 4400000 2,000,000 2,400,000 816000 5 50,000 150 7500000 4000000 500000 3000000 2,000,000 1,000,000 340000

Analysis

Budgeting

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.

Example

Comprehensive Example
Overview
STEP 2 Year EBIT Minus: Taxes Plus:Depreciation Operating Cash Flows Operating Cash Flows 0 1 2 3 4 5 1,000,000 4,500,000 4,500,000 2,400,000 1,000,000 340000 1530000 1530000 816000 340000 2,000,000 2,000,000 2,000,000 2,000,000 2,000,000 2,660,000 4,970,000 4,970,000 3,584,000 2,660,000

Analysis

Budgeting

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

Example

Comprehensive Example
Overview
STEP 3 Year Working Capital Needs 0 1 -100000 2 3 4 5 10000

Analysis

Budgeting

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.

Example

Comprehensive Example
Overview
STEP 4 Year Operating Cash Flow Less: Net working capital Less: Initial Outlay Free Cash Flow Free Cash Flow 0 -100000 -10,000,000 -10,100,000 1 2,660,000 0 2 4,970,000 0 3 4,970,000 0 4 3,584,000 0 5 2,660,000 100000

Analysis

2,660,000

4,970,000

4,970,000

3,584,000

2,760,000

Budgeting

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

Example

Comprehensive Example
Overview
Now, using the date calculate the NPV and the IRR for the Project Initial Outlay Cash inflows/Year -10,100,000 0 1 2 3 4 5 2,660,000 4,970,000 4,970,000 3,584,000 2,760,000

Analysis

Budgeting

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

Example

Comprehensive Example
Overview
Year Not Discounted Discounted Initial Outlay Required Rate SOLUTION 0 1 2,660,000 2418181.818 2 3 4 5 4,970,000 4,970,000 3,584,000 2,760,000 4107438 3734034.6 2447920.2 1713742.9

Analysis

-10,100,000 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. 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.

NPV

4,321,317

Budgeting

Example

Comprehensive Example
Overview
SOLUTION Year 0 1 2 3 4 5 Not Discounted -10,100,000 2,660,000 4,970,000 4,970,000 3,584,000 2,760,000 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.

Analysis

Budgeting

Example

Practice Problem
Using this data solve for the Free Cash Flows and then NPV and IRR. This problem is very similar to the example solved previously.
Cost of new plant and Equipment Other Costs Total Cost Total Unit Sales 1,500,000 300,000 1,800,000 Year 1 2 3 4 5 175 85 500000 100000 360,000 Sold 10,000 20,000 5,000 60,000 250,000

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

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.

Click here for answer

Summary
Cash flow analysis is crucial for the success of a project and the firm The most common type of analysis is Free Cash Flows analysis Free Cash Flows can help with further analysis as they can be used in NPV and IRR calculations

Reading List
Kewon, Martin, Petty and Scott Jr. Financial Management: Principles and Applications. New Jersey: Prentice Hall, 2000. RossWesterfieldJaffe .Corporate Finance, Seventh Edition. New York: McGrawHill Primis, 2005. CFA Institute. Corporate Finance Readings. Charlottesville, CFA Institute, 2005. http://en.wikipedia.org/wiki/Cash_flows

Bibliography
Kewon, Martin, Petty and Scott Jr. Financial Management: Principles and Applications. New Jersey: Prentice Hall, 2000.(This book was heavily drawn upon. The comprehensive example format is very similar to what the author uses in the book.) RossWesterfieldJaffe .Corporate Finance, Seventh Edition. New York: McGrawHill Primis, 2005. CFA Institute. Corporate Finance Readings. Charlottesville, CFA Institute, 2005. http://en.wikipedia.org/wiki/Cash_flows