Corporate Finance: Free Cash Flow and Capital Budgeting Notes

Corporate Finance: Free Cash Flow and Capital Budgeting

Cash Flows

  • Cash flow analysis is crucial for understanding a firm’s valuation and operations.

  • Difference between finance and accounting:

    • Accounting: Focuses on profit via accrual accounting.

    • Finance: Examines cash flows, emphasizing free cash flow (FCF).

Free Cash Flow (FCF)

  • Definition: Cash generated from ongoing business operations, available for distribution to capital providers (shareholders, bondholders).

  • Exclusions:

    • Financing terms and non-operating investments not related to normal business activity.

  • Importance of FCF lies in its relation to the firm's operating decisions rather than financing decisions.

FCF vs. Net Income (NI)

  • NI differs from FCF due to:

    • Accrual Basis: NI records revenue and expenses regardless of cash transactions.

    • Exclusions: Investment in fixed assets and non-cash expenses (like depreciation) are not included in NI.

    • Formula:
      ext{Net Income (NI)} = ext{Sales} - ext{COGS} - ext{SG ext{&}A} - ext{Interest} imes (1 - T)

  • Common issues with NI:

    • Sales on credit counted as revenue but not received in cash.

    • COGS includes non-cash items and liabilities not yet paid.

FCF Calculation Methods

  • Two methods:

    • Direct Method: Starts from cash sales, adjusting income statements to include only cash operating cash flows.

    • Indirect Method: Starts with NI and makes adjustments for non-cash, non-operating cash flows; this approach is more commonly used.

  • Adjustments for calculating FCF:

    • Add non-cash charges (e.g., depreciation).

    • Adjust for changes in net working capital (NWC).

    • Consider investments in fixed assets and after-tax interest.

Adjustments for FCF

  • Components of FCF calculation:

    • Operating Adjustments Include changes in:

    • Accounts Receivable (A/R)

    • Inventories

    • Accounts Payable (A/P)

    • Financial Adjustments:

    • Adjustments for after-tax interest income and expenses.

    • Taxes expensed but not yet paid.

  • Importance of adjusting NI:

    • NI may include non-cash and unnecessary financial flows that do not reflect operational cash flows.

Capital Budgeting

  • Definition: The process of planning and managing long-term investments in firm assets. Capital budgeting decisions revolve around asset acquisition, with a clear distinction between investment and financing decisions.

  • Evaluation Techniques:

    • Net Present Value (NPV): Present value of cash flows minus initial investment.

    • Payback Period (PP): Time needed to recover the initial investment.

    • Internal Rate of Return (IRR): Discount rate that makes NPV zero.

Incremental Cash Flows

  • Definition: Cash flows directly attributed to the project; focused on changes in future cash flow due to a specific decision.

  • Key considerations:

    • Exclude sunk costs.

    • Include opportunity costs related to asset utilization.

Additional Considerations

  • Side effects from projects can be beneficial or detrimental; these must be accounted for.

  • Financing costs should not be included in project evaluations.

  • Project cash flows adjusted for NWC must consider year-over-year changes, not overall levels.

Case Study Example: Airlines Facility Project

  • Essential steps include:

    • Estimating revenues, operating costs, and depreciation over the lifespan of the project.

    • Calculating changes in NWC and capital expenditures.

    • Estimating overall project cash flows and calculating NPV based on required returns.

Conclusion

  • Understanding FCF helps in making informed investment decisions and distinguishing between operating cash flows and cash distributions to security holders. This knowledge is crucial for effective capital budgeting and financial health assessments of firms.