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Earlier, we talked about the discount rate,
which is one of the key inputs necessary to calculate a project's NPV.
The other key input is cash flows.
How do we measure cash flows in NPV calculations?
Are they the same as net income from the income statement?
In this video, we will discuss what these cash flows are,
which we call free cash flows?
How we calculate them.
And if and how they are different from the net income.
One important thing about calculating NPV
is that we need only incremental cash flows from a project.
The company is already in operation, generating revenues and incurring costs.
The manager is trying to decide whether to accept or reject the project.
The manager needs to know how a new project changes status quo.
NPV tells a manager as to how much a project changes shareholder wealth.
This is why we said that we should accept positive NPV projects,
as it increases shareholder wealth.
While we should reject negative NPV projects,
as it decreases shareholder wealth.
So the focus is only on changes, and hence we need only incremental cash flow.
That is how much additional investment is needed today,
how much additional sales is generated, and what are the annual costs?
As part of these incremental cash flows, we need to take into account any side
effects a project may have on existing sales and costs.
We also need to account for
any opportunity cost incurred on account of the project.
We'll talk about these in a later video in greater detail.
Where do the cash flows come from?
Are they the same as net income?
The answer is no.
This goes back to our discussion of recording information on financial
statements on an accrual basis.
Remember, this means that revenues and
costs are reported on the income statement as and when the economic event occurs and
not when the cash from the event is realized.
For example,
we will record sales made on credit as part of our sales on our income statement.
The economic event, namely delivery of product or service, has already
taken place, but payment for this product or service will take place in the future.
This is an accounting view of cash flow.
It shows profits as they are earned, and not when the are realized in cash.
For NPV calculations, we need incremental cash the project generates, and
not what and when it is earned.
This means that we should exclude parts of sales and
costs from the income statement for which cash hasn't been received or paid as yet.
Remember, we had talked about the idea of expensing versus capitalizing earlier in
the course.
A cost is expensed if its benefits are realized in the same period.
On the other hand,
a cost is capitalized if its benefits are realized over a number of periods.
This gave rise to the idea of amortization and depreciation of costs.
For example, a company may pay $100 million in cash today to build a plant and
buy machinery, but the entire amount won't show up on the income statement as a cost.
It will be spread over its useful life as a depreciation expense.
This leads to overstating the amount of cash a company has on hand today, and
understating its cash in future periods.
In summary, the net income includes some cash flows and excludes others.
Further depreciation and amortization reduces net income, when in fact,
they are not cash flows at all.
The incremental cash flows we need to calculate NPV are referred to as
free cash flows, FCF in short.
It is finance's view of cash flows.
It is the cash flow generated from the project's operations, and
available for distribution to all suppliers of capital,
like banks, bondholders, shareholders, etc.
FCF captures only cash flows related to business activities or operations.
It excludes all cash flows related to financing and investing activity.
For example,
will exclude how much interest the company pays on its loans outstanding.
It also excludes investments that are not related to normal business activity.
This would exclude any income earned from investments and marketable securities.
So then, how are FCF and net income related?
Are they the same?
The answer is no.
Net income makes adjustments for non-cash expenses like depreciation expenses,
as well as costs not actually paid for,
which is captured by changes in accounts payable.
It also includes non-cash revenues,
which is captured by changes in accounts receivable.
Net income adjusts for
finance related income and costs like interest income and interest expense also.
So how do we calculate free cash flows?
You may realize that a lot of what we have said about the difference between FCFs and
net income is similar to the discussion we had when we covered the statement of cash
flows earlier.
Similar to the statement of cash flows, we can use the direct or
indirect method to calculate FCF.
The direct method is a lot more difficult to use to calculate FCF as we have to look
at the cash component of every single operations-related activity.
As with the statement of cash flows,
it is easier to use the indirect method to determine FCFs.
This would require us to start with the net income and then make adjustments for
cash and non-cash income and expenses, as well as for financing-related cash flows.
For the statement of cash flows, we separated cash flows into those from
operating, investing, and financing activities.
We started off adjusting net income by adding back depreciation expense,
adding back the interest expense, and subtracting out interest income.
We also made adjustments for operations-related current assets and
current liabilities, like inventory, accounts receivable, and accounts payable.
You should exclude any changes to cash, marketable securities,
and short term notes payable, as they are financing-related current assets and
liabilities.
Increases in current assets like inventory and
accounts receivable means that cash was spent, but not received as yet.
And so the increases need to be subtracted from net income.
On the other hand, decreases in current assets would be added to net income.
We did the opposite for current liabilities.
Increases were added and decreases were subtracted.
After all these adjustments to net income, we got cash flows from operations.
All these adjustments also apply to FCF calculations.
To arrive at the FCF, we need to subtract the cost of acquiring any fixed assets
like loan, property an equipment, and
also add any income from the disposable of old fixed assets.
After these adjustments, we arrive at the FCF for
each year of the project's useful life.
At this point, it would be useful for you to reloop the videos on cash flows from
operating activities and that on cash flow from investing activities.
Remember, we do not care about cash flows from financing activities,
as they are excluded for FCF calculations.
In summary, here's how you would calculate FCF from net income.
Add the entire depreciation and
amortization expense back to net income, which are non-cash costs.
Next, make adjustment for changes in operations-related current assets and
liabilities.
This would include largely only changes in inventory, accounts receivable,
and accounts payable.
Subtract increases in current assets and decreases in current liabilities, and
add decreases in current assets and increases in current liabilities.
Next, subtract the cost of any fixed assets acquired during the year, and
add any income from the disposal of fixed assets.
Finally, add the after tax interest expense, and
subtract any after tax interest income.
After tax means multiplying the corresponding numbers by
one minus the tax rate.
After all these adjustments to net income, we have done all FCFs.
Next time, we will look at some other relevant cash flows that affect FCF, but
are not captured in the income statement.
These largely include side effects, as well as opportunity costs.
We will also briefly discuss the idea of sunk costs and
why those are irrelevant cash flows.
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M Rammohan RaoProfessor Emeritus
Ramnarayan SubramaniamClinical Professor
Deepa ManiAssociate Professor and Executive Director, Srini Raju Centre for IT and the Networked Economy
Sudhir VoletiAssistant Professor and ISB Research Fellow
Ramabhadran ThirumalaiAssistant Professor
