Last time we saw how to calculate FCFs from financial statements. However not all relevant cash flows for the FCFs appear in the financial statements. These includes side effects and opportunity costs which we will discuss in this video. We will also discuss what sunk costs are. They may appear to be relevant to FCF calculations, but they actually are not. The first type of cash flow relevant for FCF calculations is side effects. This is the impact of the new project on firm's existing revenues and/or costs. For example, a company may be looking at providing remote IT support services. While this will bring in revenues of $10 million, some existing customers may want to switch to using remote support services. This switch will reduce revenues from existing onsite IT support services by $4 million. For FCFs, we're only interested in incremental cash flows, that is, how does the project affect status quo. So the net incremental revenues are only $10 million minus $4 million, which is $6 million. This reduction of $4 million in revenues is not captured in any form on the income statement, but it has a real impact on the company's free cash flows. Hence such side effects need to be identified and adjusted for accordingly. The new project may also help improve efficiency or reduce cost for the company. Some existing customers switching from onsite support services to remote support services, could mean that the company needs to keep fewer people on its payroll to provide services. Hence there could be a reduction in cost, which would need to be added, as any cost saving is going to result in a larger amount of cash on hand. Another relevant cash flow is opportunity cost that a company may incur from taking on a new project. The company may have earned some income but forgoes it because of the new project. Let's go back to our example on the company providing remote IT support services. It may have some building space that it is not using currently and has rented it out. Let's say that the company earns $1 million a year as rental income from this excess office space. Starting the provision of remote IT support services would require this additional office space. This means that the company would have to stop renting out the extra office space and start using it for its own purposes. Which means a loss of $1 million in annual rental income. This is an opportunity cost that the proposal to start remote support services imposes on the company's existing sources of revenues. This is a real and relevant cost, and should be included as a part of RFC of calculations. Since there is a loss of one $1 million in annual income, the $1 million should be subtracted from annual cash flows to arrive at the annual FCFs. This opportunity cost is again not obvious while calculating FCFs, but still needs to be adjusted for, as it is a real and relevant cash flow. While side effects and opportunity costs are relevant but not very obvious cash flows, there are maybe cash flows that may appear to be relevant, but in fact are not. One example of such cash flows are sunk costs. These are costs incurred before the manager decides whether to accept or reject a project. These costs are incurred regardless of what the decision is. Continuing with our example on providing the remote IT support services. Before the manager decides on whether to go ahead with providing these services or not, the company incurs a large cost in developing and testing software and other capabilities, for providing remote support services. These costs are independent of whether the manager decides to accept or reject the project, and hence are considered sunk. While you think that they are project-related cash flows and should be subtracted, these do not impact the decision to accept or reject the project. Hence sunk costs must be completely ignored while calculating FCFs. Over the last few videos, we have covered all the basics of capital budgeting. This includes an understanding of what the discount rate is and what determines it, the various investment decision tools like NPV, IRR and payback period, in addition to MIRR and profitability index. And finally, what cash flows matter and what don't. In this context we define free cash flows, how to calculate them from net income, and discuss some relevant and irrelevant cash flows.
