1. Copyright © 2012 Pearson Prentice Hall. All rights reserved. Chapter 4 Cash Flow and Financial Planning

2. © 2012 Pearson Prentice Hall. All rights reserved. 4-2 Analyzing the Firm’s Cash Flow Cash flow (as opposed to accounting “ profits ” ) is the primary ingredient in any financial valuation model. From an accounting perspective, cash flow is summarized in a firm ’ s statement of cash flows. From a financial perspective, firms often focus on both operating cash flow, which is used in managerial decision-making, and free cash flow, which is closely monitored by participants in the capital market.

3. © 2012 Pearson Prentice Hall. All rights reserved. 4-3 Depreciation Depreciation is the portion of the costs of fixed assets charged against annual revenues over time. Depreciation for tax purposes is determined by using the modified accelerated cost recovery system (MACRS). On the other hand, a variety of other depreciation methods are often used for reporting purposes.

4. © 2012 Pearson Prentice Hall. All rights reserved. 4-4 Developing the Statement of Cash Flows The statement of cash flows summarizes the firm ’ s cash flow over a given period of time. Firm ’ s cash flows fall into three categories: –Operating flows: cash flows directly related to sale and production of the firm ’ s products and services. –Investment flows: cash flows associated with purchase and sale of both fixed assets and equity investments in other firms. –Financing flows: cash flows that result from debt and equity financing transactions; include incurrence and repayment of debt, cash inflow from the sale of stock, and cash outflows to repurchase stock or pay cash dividends.

5. © 2012 Pearson Prentice Hall. All rights reserved. 4-5 Table 4.3 Inflows and Outflows of Cash

6. © 2012 Pearson Prentice Hall. All rights reserved. 4-6 Interpreting Statement of Cash Flows The statement of cash flows ties the balance sheet at the beginning of the period with the balance sheet at the end of the period after considering the performance of the firm during the period through the income statement. The net increase (or decrease) in cash and marketable securities should be equivalent to the difference between the cash and marketable securities on the balance sheet at the beginning of the year and the end of the year.

7. © 2012 Pearson Prentice Hall. All rights reserved. 4-7 Operating Cash Flow A firm ’ s operating Cash Flow (OCF) is the cash flow a firm generates from normal operations — from the production and sale of its goods and services. OCF may be calculated as follows: NOPAT = EBIT  (1 – T) OCF = NOPAT + Depreciation OCF = [EBIT  (1 – T)] + Depreciation

8. © 2012 Pearson Prentice Hall. All rights reserved. 4-8 Operating Cash Flow (cont.) Substituting for Baker Corporation, we get: Thus, we can conclude that Baker ’ s operations are generating positive operating cash flows. OCF = [$370  (1 –.40)] + $100 = $322

9. © 2012 Pearson Prentice Hall. All rights reserved. 4-9 Free Cash Flow Free cash flow (FCF) is the amount of cash flow available to investors (creditors and owners) after the firm has met all operating needs and paid for investments in net fixed assets (NFAI) and net current assets (NCAI). Where: FCF = OCF – NFAI – NCAI NFAI = Change in net fixed assets + Depreciation NCAI = Change in CA – Change in (A/P + Accruals)

10. © 2012 Pearson Prentice Hall. All rights reserved. 4-10 Free Cash Flow (cont.) Using Baker Corporation we get: Thus, the firm generated adequate cash flow to cover all of its operating costs and investments and had free cash flow available to pay investors. FCF = $322 – $300 – $0 = $22 NFAI = [($1,200 – $1,000) + $100] = $300 NCAI = [($2,000 – $1,900) + ($800 - $700)] = $0

11. © 2012 Pearson Prentice Hall. All rights reserved. 4-11 The Financial Planning Process The financial planning process begins with long-term, or strategic, financial plans that in turn guide the formulation of short-term, or operating, plans and budgets. Two key aspects of financial planning are cash planning and profit planning. –Cash planning involves the preparation of the firm ’ s cash budget. –Profit planning involves preparation of pro forma statements.

12. © 2012 Pearson Prentice Hall. All rights reserved. 4-12 The Financial Planning Process: Long-Term (Strategic) Financial Plans Long-term (strategic) financial plans lay out a company ’ s planned financial actions and the anticipated impact of those actions over periods ranging from 2 to 10 years. Firms that are subject to high degrees of operating uncertainty, relatively short production cycles, or both, tend to use shorter planning horizons. These plans are one component of a company ’ s integrated strategic plan (along with production and marketing plans) that guide a company toward achievement of its goals.

13. © 2012 Pearson Prentice Hall. All rights reserved. 4-13 The Financial Planning Process: Long-Term (Strategic) Financial Plans Long-term financial plans consider a number of financial activities including: –Proposed fixed asset investments –Research and development activities –Marketing and product development –Capital structure –Sources of financing These plans are generally supported by a series of annual budgets and profit plans.

14. © 2012 Pearson Prentice Hall. All rights reserved. 4-14 The Financial Planning Process: Short-Term (Operating) Financial Plans Short-term (operating) financial plans specify short- term financial actions and the anticipated impact of those actions. Key inputs include the sales forecast and other operating and financial data. Key outputs include operating budgets, the cash budget, and pro forma financial statements. This process is described graphically on the following slide.

15. © 2012 Pearson Prentice Hall. All rights reserved. 4-15 Figure 4.1 Short-Term Financial Planning

16. © 2012 Pearson Prentice Hall. All rights reserved. 4-16 Cash Planning: Cash Budgets The cash budget or cash forecast is a statement of the firm ’ s planned inflows and outflows of cash that is used to estimate its short-term cash requirements. Typically, the cash budget is designed to cover a 1-year period, divided into smaller time intervals. The more seasonal and uncertain a firm ’ s cash flows, the greater the number of intervals.

17. © 2012 Pearson Prentice Hall. All rights reserved. 4-17 Cash Planning: Cash Budgets (cont.) A sales forecast is a prediction of the sales activity during a given period, based on external and/or internal data. The sales forecast is then used as a basis for estimating the monthly cash flows that will result from projected sales and from outlays related to production, inventory, and sales. The sales forecast may be based on an analysis of external data, internal data, or a combination of the two. –An external forecast is a sales forecast based on the relationships observed between the firm ’ s sales and certain key external economic indicators. –An internal forecast is a sales forecast based on a buildup, or consensus, of sales forecasts through the firm ’ s own sales channels.