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.
