1. Financial management: lecture 7 Free Cash Flows in Finance Calculate future cash flows

2. Financial management: lecture 7 Today’s agenda Review what we have learned in the last week How to calculate the cash flows in the future

3. Financial management: lecture 7 Some points to remember in calculating free cash flows Depreciation and accounting profit Incremental cash flows Change in working capital requirements Sunk costs Opportunity costs Forget about financing

4. Financial management: lecture 7 Cash flows, accounting profit and depreciation Discount actual cash flows Using accounting income, rather than cash flows, could lead to wrong investment decisions Don’t treat depreciation as real cash flows

5. Financial management: lecture 7 Example A project costs $2,000 and is expected to last 2 years, producing cash income of $1,500 and $500 respectively. The cost of the project can be depreciated at $1,000 per year. Given a 10% required return, compare the NPV using cash flow to the NPV using accounting income.

6. Financial management: lecture 7 Solution (using accounting profit)

7. Financial management: lecture 7 Solution (using cash flows)

8. Financial management: lecture 7 Forget about financing When valuing a project, ignore how the project is financed. You can assume that the firm is financed by issuing only stocks; or the firm has no debt but just equity

9. Financial management: lecture 7 Incremental cash flows Incremental cash flows are the increased cash flows due to investment Do not get confused about the average cost or total cost? Do you have examples about incremental costs? Incremental Cash Flow cash flow with project cash flow without project = -

10. Financial management: lecture 6 Working capital Working capital is the difference between a firm’s short-term assets and liabilities. The principal short-term assets are cash, accounts receivable, and inventories of raw materials and finished goods. The principal short-term liabilities are accounts payable. The change in working capital represents real cash flows and must be considered in the cash flow calculation

11. Financial management: lecture 7 Example We know that inventory is working capital. Suppose that inventory at year 1 is $10 m, and inventory at year 2 is $15. What is the change in working capital? Why does this change represent real cash flows?

12. Financial management: lecture 7 Sunk costs The sunk cost is past cost and has nothing to do with your investment decision Is your education cost so far at SFSU is sunk cost?

13. Financial management: lecture 7 Opportunity cost The cost of a resource may be relevant to the investment decision even when no cash changes hands. Give me an example about the opportunity cost of studying at SFSU?

14. Financial management: lecture 7 Be consistent in how you handle inflation!! Use nominal interest rates to discount nominal cash flows. Use real interest rates to discount real cash flows. You will get the same results, whether you use nominal or real figures Inflation rule

15. Financial management: lecture 7 Example You own a lease that will cost you $8,000 next year, increasing at 3% a year (the forecasted inflation rate) for 3 additional years (4 years total). If discount rates are 10% what is the present value cost of the lease?

16. Financial management: lecture 7 Inflation Example - nominal figures

17. Financial management: lecture 7 Inflation Example - real figures

18. Financial management: lecture 7 How to calculate free cash flows? Free cash flows = cash flows from operations + cash flows from the change in working capital + cash flows from capital investment and disposal We can have three methods to calculate cash flows from operations, but they are the exactly same, although they have different forms.

19. Financial management: lecture 7 How to calculate cash flows from operations? Method 1 Cash flows from operations =revenue –cost (cash expenses) – tax payment Method 2 Cash flows from operations = accounting profit + depreciation Method 3 Cash flows from operations =(revenue – cost)*(1-tax rate) + depreciation *tax rate

20. Financial management: lecture 7 Example revenue 1,000 - Cost 600 - Depreciation 200 - Profit before tax 200 - Tax at 35% 70 - Net income 130 Given information above, please use three methods to calculate Cash flows

21. Financial management: lecture 7 Solution: Method 1 Cash flows=1000-600-70=330 Method 2 Cash flows =130+200=330 Method 3 Cash flows =(1000-600)*(1-0.35)+200*0.35 =330

22. Financial management: lecture 7 A summary example ( Blooper) Now we can apply what we have learned about how to calculate cash flows to the Blooper example, whose information is given in the following slide.

23. Financial management: lecture 7 Blooper Industries (,000s)

24. Financial management: lecture 7 Cash flows from operations for the first year or $3,950,000

25. Financial management: lecture 7 Blooper Industries Net Cash Flow (entire project) (,000s) NPV @ 12% = $3,564,000