Cash Flow

CASH FLOWS1 1) Introduction • The starting point for any financial decision is to assess the correct cash flows associated with that decision. The focus in this note is on deriving the conceptually ‘correct’ cash flows for the purposes of capital budgeting and corporate valuation. The correct measure of cash flow for both purposes is the ‘free cash flow,’ often just called ‘cash flow.’ There are important differences between ‘cash flow’ and the notion of ‘profit’ or ‘net income’ found in accounting statements. Net income is not the same as cash flow. There are three basic concepts to apply when deriving cash flow: i) ii) Inflows and outflows of funds are accounted for as cash flow only when they actually occur; The definition of cash flow excludes all funds flows associated with ways of financing the investment.––i.e., cash flow reflects solely the outcome of operating and investing decisions of a project or a division or a company, not its financing decisions; Project cash flow should only consider flows that are specific to the project under consideration––i.e., project cash flow should be derived incrementally, or as an addition to an existing set of activities in the division or the firm.

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2) Two Basic Types of Cash Flow: Operating Cash Flow and Free Cash Flow Define the following with respect to a division or a firm or a project: Rev CGS SGA EBITDA Dep EBIT Int EBT Tax tc NI Capex NWC = = = = = = = = = = = = = Revenues Cost of goods sold Selling, general, and administrative expenditures Rev – CGS – SGA Depreciation and Tax-deductible Amortization EBITDA – Dep Interest Expenses EBIT – Int Total cash taxes paid Corporate (cash) tax rate (= Tax/EBT) Net income = EBT – Tax = EBT*(1 – tc) Net capital expenditure Net working capital (= Curr. assets – Curr. liabilities)

This note was developed by Anant K. Sundaram, Faculty Director of Executive Education, Tuck School of Business at Dartmouth. © 2003 (Revised 5/04).

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