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
Analysis
Budgeting
Example
• Profits under the accounting system
are calculated on accrual basis rather
than cash basis
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
Example
•
•
•
•
•
Statement of CF Analysis
Free Cash Flows
Payback Period
Net Present Value
Internal Rate of Return
Statement of CF Analysis
Overview
• Cash Flow from Operating Activities
Analysis
• Cash Flow from Investing Activities
Budgeting
• Cash Flow from Financing Activities
Example
Free Cash Flows
Overview
Analysis
Operating Income (Earning before interest
and taxes)
+Depreciation
= EBITDA (Earnings before interest, taxes, Depreciation,
and amortization)
Budgeting
-cash tax payments
= after-tax cash flows from operations
Example
Payback Period
Overview
Analysis
Budgeting
Example
• A criteria used in capital budgeting.
Defined as the number of years
required to recover initial cash
investment
Payback Period: Example
Overview
Initial Investment in project
Analysis
Year 1
Year 2
Year 3
Year 4
Year 5
Budgeting
Payback
Example
10000
Cash inflows after -tax
1000
1000
5000
4000
5000
3.3
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
Budgeting
Example
• 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
NPV: Example
Overview
Analysis
Budgeting
Initial Outlay
Required Rate
Year 1 Inflow
Year 2 Inflow
Year 3 Inflow
Year 4 Inflow
Year 5 Inflow
Sum
NPV
Example
-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
We take the sum of the
discounted values and
subtract the initial
outlay.
Internal Rate of Return
Overview
Analysis
Budgeting
Example
• 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
IRR: Example
Overview
Analysis
Initial Outlay
Year 1 Cash Inflow
Year 2 Cash Inflow
Year 3 Cash Inflow
-3817
1000
2000
3000
Budgeting
IRR
Example
22%
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.
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
Example
• Use Free Cash Flows Rather than
accounting Profits
• Only worry about incremental Cash
Flows
• Cash Flow diversion from other
Product Categories
Capital Budgeting Guidelines
Overview
Analysis
Budgeting
Example
• Look for Incidental or Synergistic
Effects
• Working-Capital Requirements
• Incremental Expenses
• Opportunity Costs
Comprehensive Example
Overview
Cost of new plant and Equipment
Other Costs
Total Cost
Total Unit Sales
Analysis
Budgeting
Sales price per unit
Variable cost
Fixed Costs
Required Working Capital
Depreciation
Example
We just added the total cost
of plant with other costs and
divided it by 5 years to get a
straight line decpreciation.
9,700,000
300,000
10,000,000
Year
1
2
3
4
5
Sold
50,000
100,000
100,000
70,000
50,000
150
80
500000
100000
2,000,000
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
Analysis
Budgeting
STEP 1
EBIT, TAXES and DEPRECIATION are calculated here
Year
Units Sold
Sale Price
Sales Revenue
Less: Variable Costs
Less: Fixed Costs
EBDIT
Less: Depreciation
EBIT
Taxes (@ 34%)
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
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
Analysis
Budgeting
Example
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
Depreciation is added back here as we move toward Free
cash flows. Here Operating Cash Flows are derived.
Comprehensive Example
Overview
STEP 3
Year
Analysis
Budgeting
Example
Working Capital Needs
0
1
-100000
2
3
4
5
10000
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.
Comprehensive Example
Overview
STEP 4
Analysis
Budgeting
Example
Free Cash Flow
Year
Operating Cash Flow
Less: Net working capital
Less: Initial Outlay
0
-100000
-10,000,000
Free Cash Flow
-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
2,660,000
4,970,000
4,970,000
3,584,000
2,760,000
Finally we have the free cash flows that we can use in our
NPV and IRR calculations.
Comprehensive Example
Overview
Now, using the date calculate the NPV and the IRR for the Project
Analysis
Budgeting
Example
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
Depending on the answer also recommend if the project should be accepted.
Comprehensive Example
Overview
Analysis
SOLUTION
Year
Not Discounted
Discounted
Initial Outlay
Required Rate
NPV
Budgeting
Example
0
-10,100,000
10.00%
4,321,317
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
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.
Comprehensive Example
Overview
SOLUTION
Analysis
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
Budgeting
Example
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.
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
1,500,000
300,000
1,800,000
Total Unit Sales
Year
1
2
3
4
5
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.
Sold
10,000
20,000
5,000
60,000
250,000
175
85
500000
100000
360,000
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.
• Ross−Westerfield−Jaffe .Corporate Finance, Seventh
Edition. New York: McGraw−Hill 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.)
• Ross−Westerfield−Jaffe .Corporate Finance, Seventh
Edition. New York: McGraw−Hill Primis, 2005.
• CFA Institute. Corporate Finance Readings.
Charlottesville, CFA Institute, 2005.
• http://en.wikipedia.org/wiki/Cash_flows