BUSFIN 4211: 3.2: Capital Budgeting: Free Cash Flows

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The firm cannot invest its earnings into old or new projects and/or pay the shareholders with earnings

• Cash is necessary to survive

• Free cash flows (FCF) represent

the incremental effect of a project on the firm’s available cash

Obtain FCFs from earnings by doing the following adjustments that stem from the balance sheet:

1) Add back depreciation because non-cash expense

2) Subtract increase in net working capital (NWC) because of accruals

3) Subtract capital expenditures (CapEx) since actual cash flow

𝐹𝐶𝐹 =

𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 + 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 – 𝐶𝑎𝑝𝐸𝑥 − ∆𝑁𝑊𝐶

𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠:

After-tax income as defined before

𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛:

Added back because it is not a cash flow

𝐶𝑎𝑝𝐸𝑥:

Capital expenditures are cash expenses

∆𝑁𝑊𝐶:

Change in net working capital

CHANGE, not current level.

Depreciation is not a

cash flow, but it affects tax payments

CapEx

• Property, plants, and equipment (PP&E)

• Most often upfront costs (time 0), but not always (delayed investment)

Spending on capital assets cannot be deducted from pre-tax income

• The government specifies a “tax life” for the asset and its cost is “written off” as a

depreciation expense each year during the tax life

• Depreciation is not a cash flow: non-cash expense

Sales that are not paid for immediately are (also) recorded as

• accounts receivable (AR)

• Need to subtract any increase in AR

An increase in AR is

bad news from a cash flow point of view

A decrease in AR is

good news from a cash flow point of view

Expenditures not paid for immediately are (also) recorded as

accounts payable (AP)

So: Need to subtract any decrease in AP

An increase in AP is

good news from a cash flow point of view

A decrease in AP is

bad news from a cash flow point of view

Net Working Capital (NWC)

the amount of money a company has available to operate after deducting its current liabilities from its current assets.

NWC

= current assets – current liabilities

= cash + inventory + receivables – payables

Firms “invest” in NWC (= bad news from cash flow point of view)

• Increase cash reserves

• Increase inventories

• Increase accounts receivable

• Decrease accounts payable

Key intuition:

An investment in NWC takes dollars away from shareholders, hence we

subtract any increase in NWC when calculating the project’s free cash flow

Only changes in net working capital impact

cash flows

Net Working Capital:

Current assets minus current liabilities

• Exclude short-term debt because financing decisions are separate

𝑁𝑊𝐶 = 𝐶𝑎𝑠ℎ + 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 + 𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒𝑠 − 𝑃𝑎𝑦𝑎𝑏𝑙𝑒𝑠

𝐶𝑎𝑠ℎ:

Cash and equivalents (and short-term investments)

𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦:

Value of goods currently held for sale

𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒𝑠:

Accounts receivable from past sales (to customers)

𝑃𝑎𝑦𝑎𝑏𝑙𝑒𝑠:

Accounts payable for past purchases (from suppliers)

Over the long-run, cash flows ~ earnings since accruals “get settled”

• Undiscounted sum of earnings = undiscounted sum of FCFs (more or less)

• But the timing of the cash flows is crucially important to discounting (NPV)

• And the timing of the cash flows is critical for individual finite projects

Earnings are the focus of Wall Street, the media, CFOs, analysts…

• Stock prices react to current earnings news

• Indeed, earnings are a great smooth estimate of the value today of the firm as an ongoing

concern (more to come when we talk about stock valuation)

• No inconsistency with value created as NPV = sum of discounted FCFs