2.3 Free Cash Flow

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En provenance du cours de Yonsei University

Applying Investment Decision Rules for Startups

20 notes

Yonsei University

Applying Investment Decision Rules for Startups

20 notes

Cours 4 sur 5 dans Specialization Valuation and Financial Analysis For Startups

In the previous course, you learned financial statement analysis and how to make estimate of future financial status. In this course, you are going to learn capital budgeting. That is, how to make an investment decision. You would like to select the best project among various projects you can take. Then, you need to know the criteria. In this course, you are going to learn investment decision criteria such as NPV and IRR, which are most popular decision rules. Using financial analysis and discounted cash flow method, you can make pro forma financial statement and estimate project cash flows. Then, you apply investment criteria to determine whether to invest or not. After learning how to apply NPV and IRR method to investment decision, you are going to learn how to evaluate NPV estimate and scenario, what-if analyses and break-even analysis. In addition to NPV and IRR, you are going to learn Payback period method and Profitability method to determine whether to invest or not when there is a political risk or capital rationing.

À partir de la leçon

Project Analysis

In this module, you will learn how to estimate project cash flows using Excel. Overall, project cash flow analysis is similar to firm-level cash flow analysis. However, there also exist some unique features of a project cash flow analysis, which requires us to study the project cash flow principles.

2.1 Project Cash Flow Principles5:43

2.2 Pro Forma Income Statement9:20

2.3 Free Cash Flow8:15

2.4 Sensitivity Analysis9:24

Rencontrer les enseignants

Saeyeul Park
Assistant Professor
School of Business

Hi, in this lecture we will now shift our focus from income statement

analysis to cash flow analysis.

After all,

it is cash flows that occur in earnings that determine value of a project.

To compute the total cash flows from assets, or

the project, we should consider the following items.

Cash flow from assets is calculated as operating cash flow minus

capital expenditure minus change in net working capital plus salvage value.

Now we'll take a look at each of those four components.

First, the operating cash flow, or OCF,

is calculated as operating income minus taxes plus depreciation.

This is why we had to construct the pro forma income statement first.

By subtracting taxes and by adding back depreciation we are converting

operating income into operating cash flow.

Next we consider capital expenditure, or initial outlay, of the project.

We often use terms initial investment, or initial outlay,

because the expenditure is usually incurred at the beginning of the project.

For convenience, we will include the present value of the opportunity cost in

this item later in Excel spreadsheet.

We know that the change in net working capital affects cash flows negatively.

A rough definition of net working capital

is current assets minus current liabilities.

And some important items in net working capital are account receivable,

inventories, and account payable.

An increase in net working capital means a cash outflow, and

a decrease in net working capital means a cash inflow.

Why?

Because net working capital committed to the project cannot be used elsewhere and

would present a cash outflow from the former's perspective.

How about salvage value?

Sometimes assets have a positive resale value at the end of the project.

But remember, we should use the after tax cash flow from salvage value.

If the actual resale price happens to be greater than the net

book value of the asset, we should pay taxes, or the difference.

That is, the after tax salvage is calculated as resale value

minus tax rate times the difference between resale value and book value.

Also do not forget to consider

the salvage value of net working capital at the end of the project.

Because net working capital that has been tied up to the project is

freed up at the end of the project.

Now in the spreadsheet we will calculate year by year cash flows from assets.

Again, the four components of total cash flows are operating cash flow,

capital expenditure, change in net working capital, and salvage value.

We first calculate operating cash flows starting from year one.

It is the operating income, C14, minus taxes,

C15, plus depreciation, C13.

So we just converted operating income into operating cash flow.

We can finish row 20 by copying the formula to the right.

Next, the initial investment in the assumption table was $6,500.

That is the apex of this project in year zero.

Also, earlier, we decided that we include the opportunity cost in this item too

because otherwise we will need to create a new row just for the opportunity cost.

So it looks like the cash outflow in year zero will be $7,500 for this project.

Next we want to calculate the change in net working capital.

But to calculate changes we need to get year by year net working capital first.

In cell B23 we calculate the required net working

capital in year zero, which should be calculated as revenue

in that year times net working capital requirement rate,

which was 15% as you can see in the assumption table.

Of course, net working capital in year zero is zero.

Because the operation hasn't started yet.

But as the project starts to generate revenue, starting from year one,

it also has required net working capital as can be seen in row 23.

The change in net working capital can be measured starting from year one because

we do not have the previous year's net working capital in year zero.

In the formula the change is simply the difference between

the current period's net working capital Z23, and

the previous period's net working capital B23.

In year one the change in net working capital is about 1,100.

Is this good news in terms of cash flows?

No, the huge increase in net working capital

will negatively impact the cash flow in year one.

You can calculate the changes in other years by copying the formula.

Finally, we consider salvage value.

A cash flow from salvage value is incurred only once

in the final year of the project.

So we'll work on it in cell H24 only.

The first part of the formula deals with sales value of fixed assets.

We first take the estimated resale value, 1,000 in cell E5,

and then we consider the tax we should pay for

the difference between resale value E5 and book value E4.

The difference is multiplied by the tax rate B6. Finally,

we add cell H23 in the formula,

which is the size of net working capital at the end of the project.

The total salvage value at the end of year six is about $2,300.

You're almost done.

We just need to calculate total cash flows by taking operating cash flow

minus CAPEX minus change in networking capital plus salvage value.

So we got the total cash flow in year zero, and

we can get total cash flows in other years by copying the formula to the right.

Okay, so finally we have estimated

the project’s yearly cash flows as shown in the last row of this table.

Now we are able to perform fundamental capital budgeting analysis,

such as NPV and IRR, because we just got cash flows and we know the discount rate.

In the next lecture, we'll actually make investment decisions for

this project using techniques we learned earlier and

also perform a sensitivity analysis for the project.

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