Cash Flows We generally use the stand alone principle when looking at cash flows.

This means looking at the cost and revenues (cash flows) of this project/asset by itself. When projects have unequal lives we have to assume either as of the end of the shorter or chain projects together till the end of the longer. (Or assume some rate). Replacement Chain or EAA ` Opportunity Cost must be considered when making Capital Budgeting decisions. We engage in one project and give up potential returns in another. As an example, if we already own an asset (like a piece of land) and use it for A, we can not then use it for B, forcing us to give up the return we would garner from B. Side Effects refer to the effect one project may have on another. For example, when Ford introduced the Contour, it fully expected it to cut into sales of the Tempo, which it would then stop making a year later. However a base model of the Tempo had such a low price, compared to the new Contour, that sales of the Contour were much lower than expected, and never did take off like they thought. Sunk Cost must also be considered. We need to compute (and recomputed) the expected return on a project as we progress in it; and determine what the best course of action would be from here. Funds that have already been spent are not a good reason to spend more. We normally start with pro forma financial statements, which generally begin with forecasted sales. Given our sales forecast we can start to compute our Project cash flow. 1) Operating Cash Flow = EBIT + Depreciation Taxes

The next step is to look at Capital Spending

2)

Capital Spending = Ending Net Fixed Assets Beginning Net Fixed Assets + Depreciation Finally, we need to look at Changes in Net Working Capital 3) (Cash + Accounts Receivable + Inventory) minus (Accounts Payable + Notes Payable) = Net Working Capital and Change in Net Working Capital = Ending Net Working Capital Beginning Net Working Capital

We can check this by using the other Cash Flow Formula. Cash Flow to Creditors + Cash Flow to Stockholders 1) Cash Flow to Creditors = Interest paid Net new borrowing (long term debt) 2) Cash Flow to Stockholders = Dividends paid Net new equity (Common stock and Paid in Surplus) If we did things right we should get the same answer both ways. For Example:
01 B/S (in 000's) Cash Accounts receivable Inventories Total Current Assets Net Fixed Assets Total Assets 20.00 240.00 240.00 500.00 500.00 1000.00 Accounts Payable Notes Payable Total Current Liabilities Long-Term Debt Common Stock Retained Earnings Total Liabilities and equity Forecast Sale Increase Income Statement '01 Pro Forma '02 I/S 100.00 100.00 200.00 100.00 500.00 200.00 1000.00 = 25 %

Increase everything except depreciation by 25 %. Depreciation may be a fixed % of Net Plant & Equipment Here we will assume it is 5 % of our Fixed Assets Sales COGS Fixed Expenses Depreciation EBIT Interest Expense Earnings Before Tax Tax (40 %) Net Income Dividends (30%) Additions to R/E 02 B/S (in 000's) Cash Accounts receivable Inventories 2000.00 1200.00 -675.00 -25.00 100.00 16.00 84.00 33.60 50.40 15.12 35.28 Sales COGS Fixed Expenses Depreciation EBIT Interest Expense Earnings Before Tax Tax (40 %) Net Income Dividends (30%) Additions to R/E 2500.00 1500.00 -843.75 -31.25 125.00 20.00 105.00 42.00 63.00 18.90 44.10

25.00 300.00 300.00

Accounts Payable Notes Payable Total Current Liabilities

125.00 125.00 250.00

Total Current Assets Net Fixed Assets Total Assets

625.00 625.00 1250.00

Long-Term Debt Common Stock Retained Earnings Total Liabilities and equity

125.00 630.90 244.10 1250.00 155.9 with sales.

AFR = Assume the ratio of cash to sales is consistent ( 1.0 %) Assume accounts receivable and Inventory will increase proportionately with sales P & E may or may not increase with sales. Here we will assume it does. Accounts Payable and Notes Payable will increase with sales. 02 Retained Earnings = '01 Retained Earnings + '02 Additions to R/E AFR = Additional funds required to balance the equation. Above, it is 1250 - 1094.1 = 155.9 If we want to keep the same capital structure; 300/1000 = 30 % debt in ' 01 and 700/1000 = 70 % equity in '01,so for '02 .3*1250 = 375 and 375 - 250 = 125, so LTD must = 125. Then 1250 TA - 1119.1 TL & E = 130.9 in additional Common Stock Now to do cash flow for '02; EBIT Depr. Taxes Operating Cash Flow = Ending Fixed Assets Beginning Fixed Assets Depr. Capital Spending = 125 31.25 42 114.25 625 500 31.25 156.25 End 25 300 300 625 125 125 250 375 Beginning 20.00 240.00 240.00 500.00 100.00 100.00 200 300 75 114.25 156.25 75 -117 20 <--------

Cash Acccounts Receivable Inventory Current Assets Accounts Payable Notes Payable Current Liabilities CA - CL = NWC Change in NWC =

Operating Cash Flow = Capital Spending = Change in Net Working Capital = Project Cash Flow From Assets = Interest Paid

Net Net Borrowing CF to Creditors = Dividends Paid Net New Equity C/F to Stockholders Project Cash Flow To Creditors & Stockholders

25 -5 18.9 130.9 -112 -117 <--------