Cash Flows: Important Principles

Estimate all cash flows on an incremental basis

Create a cash flow timeline, A, for the firm without the project.
Create a cash flow timeline, B, for the firm with the project.
The project value is the incremental cash flows generated i.e. cash flows of B-A.

Do not forget the importance of year 0 and the last year of the chosen timeline for the project

In year 0, Capital Expenditures and Working Capital will be incurred.
Working Capital typically includes Cash, Inventory, AR and AP
At the end of the project, there's terminal value or sale of inventory.

Account Issues are Important

Depreciation is the main issue because it's made up - And similar non-cash items.
Capital: a) Capex and b) Working Capital - Think about changes.

Do not mix financing with operations

Stay on the asset side. Value is generated on the asset side.
When you are doing project analysis, don't worry about financing for two reasons:

1. Money is generated by your ideas, not by financing
2. When you are discounting your cash flow, you are taking financing into account
3. Your ideas generate cash flows and financing just divides up the cash flows

Include effects of inflation/deflation

When projecting prices, take into account inflation or deflation.
Inflation is always in the discount rate, r.

Do not compare projects with unequal lives

Cash Flows from Project/Operations

Cash Flows from Project/Operations

  Revenues
- Costs of Goods Sold
- Selling, General & Admin. costs
- Depreciation
--------------------------------------
= Operating Profits
- Cash Taxes on Operating Profit
--------------------------------------
= Net Operating Profits After Tax
+ Depreciation
- Capital Expenditures
- Increases in Working Capital
--------------------------------------
= Cash Flows from Operations

Depreciation: Think of depreciation as the main non-cash item that has tax implications.
Working Capital = Cash + Inventory + Acct Receivable - Acct Payable

The dangers of using IRR

Value creation is most important when it impacts a lot of people and when it lasts a long time. And IRR has a bias for small, low-impact and short-term projects.

 IRR has a short-term bias

Be careful when using IRR. Do not compare IRR of one project with another project because they are internal rates.

All value is relative.
Instead of comparing IRR percentages to each other, compare the IRR percentages to a benchmark - the cost of capital outside.

IRR calculations favors projects with earlier cash flows - IRR has a short-term bias.
IRR is myopic in that it favours shorter term returns.

Be wary when IRR is used as the decision-making criteria - it indicates a myopic point of view.

Example Calculation

Consider Projects A and Project B:

• Project A Cash flows: [ -2000, 400, 2400 ]  -  IRR = 20%
• Project B Cash flows: [ -2000, 2000, 625 ]  -  IRR = 25%

Try computing the NPV of the two projects for discount rate of 5%, 11% and 20%.
Also, try drawing the graph of NPV vs r for the two projects.

IRR has a small-investment bias

Consider Project A and Project B:

• Project A Cash flows: [ -5000, 7500 ]  -  IRR = 50%
• Project B Cash flows: [ -50,000, 62500 ]  -  IRR = 25%

What is the Internal Rate of Return (IRR)

What is IRR

The Internal Rate of Return (IRR) is the rate of return you earn on your project.

The Internal Rate of Return (IRR) is the return such that NPV is zero.
An investment is worthwhile if IRR is greater than R, the next best competing alternative.

The rate of return is internal because it is the rate of return specific to the project. All that is needed is the cash flows for that project. Compared it to NPV, which requires cash flows and the discount rate, r.

Decision Making using IRR

IRR by itself doesn't mean anything.
IRR needs to be compared to r.
When IRR > r, then the idea/project is worth pursuing because NPV will be positive.

What is the NPV of an idea?

The Net Present Value of an idea is the value created by the idea.

Interest rate, R, in Net Present Value

Where does the interest rate, r, used in computing net present value come from?

• r comes from the next best use of your investment, or other people's investment on a similar project
• r does not belong to your project
• r is that return from investing in say a competitor

In Finance, always look forward

An interesting mindset of Finance is to always look forward - time travel if you have to.

A specific application is when calculating the amount owed at a point in time.
Instead of computing the entire loan amortization table to answer the question, it is easier to simply "time travel" to the point-in-time of interest and look forward to see how many payments are outstanding and do an PV calculation.

Simple Future Value and Present Value

Simple Future Value

FV = PV * (1 + r)^n

Simple Present Value

PV = FV / (1 + r)^n

In Finance, the term "Discounted ..." means present value

The meaning of "Discounted ..." in Finance simply refers to the present value of something.

The reasoning goes like this.
A dollar today is worth more than a dollar tomorrow.
A dollar tomorrow is worth less than a dollar today.
A dollar tomorrow is discounted (thus worth less) to get its present value.

For example, discounted cash flow simply means the present value of all the future cash flows.

Represent Real-World Finance Problems with Timelines

 Represent problems on the timeline with periods 0, 1, 2 ... to n.
Understand what happens during each period to get a sense of what happens at period n.

An Introduction to Introduction To Finance

Introduction

I like the introduction of Dr Kaul Introduction to Finance course:

Finance is the study of value.

The notion of value is tightly linked to the notion of better. Higher value = better.

What can I expect to learn?

A framework and the tools to value almost anything. I also expect to learn a value-based perspective.

How can I expect to be better?

I'll be able to make value-based decision making.

Some quotes:

I will not use a formula unless I can explain it in words... force yourself, to first say it in words before using the formula because I think the formula reflects what we are thinking, not the other way around. And that's one of the problems of Finance and Technical areas, that we somehow think, that, just because there's Math, there's a definitive answer. 

All answers are wrong. There's a bunch of assumptions, that we make in valuing things and it's your assumptions and way of thinking, that's the value part, not the final answer. Anybody can crank through Excel and come up with an answer, it doesn't mean much.