Understanding Relevant Cash Flows and Their Impact

Relevant cash flows are a crucial aspect of financial analysis, particularly in the context of mergers and acquisitions. Relevant cash flows can be either positive or negative, and they can significantly impact a company's financial position.

A positive relevant cash flow indicates that a company has generated more cash than it has used, resulting in an increase in its cash balance. For instance, in Section 2, we saw how XYZ Corporation increased its cash balance by $10 million in the last quarter.

Relevant cash flows can also have a significant impact on a company's ability to pay its debts. As we learned in Section 3, ABC Inc. was able to pay off its outstanding loans due to its strong relevant cash flow.

A fresh viewpoint: What Financial Ratios Are Important to Cash Flow Statement

Relevant cash flows are a crucial concept in business, and understanding them can make a big difference in decision-making. They refer to cash flows that occur in the future and are incremental, meaning they arise because of a specific decision.

Only costs or revenues that give rise to a cash flow should be included in relevant cash flows. This means excluding sunk costs, which are costs that have already been paid and cannot be changed.

Relevant cash flows should arise in the future, not in the past. Anything that has occurred in the past is a sunk cost and should be excluded. For example, if a business owner has already paid $1,000 for advertising, this is a sunk cost and should not be included in relevant cash flows.

Only cash flows that arise because of the decision being made should be included. This means excluding committed costs, which are costs that would have arisen anyway, regardless of the decision.

Opportunity costs are also relevant cash flows, as they represent the revenues lost or additional costs that arise from moving existing resources from their current use.

Here are the key characteristics of relevant cash flows:

Calculating After-Tax Free Cash Flow is a crucial step in evaluating a project's investment. After-tax FCF includes any incremental capital expenditures as well as any addition to working capital required for the project.

To calculate after-tax FCF, we need to consider the yearly incremental operating cash flows resulting from the project. This involves evaluating each project's investment, revenue, and expenses independently from the company that owns that project.

The after-tax FCF calculation involves six steps, which are outlined below:

1. Compute earnings before interest, tax, depreciation, and amortisation (EBITDA) by subtracting operating expenses from revenue.

2. Compute earnings before interest and tax (EBIT) by subtracting depreciation and amortisation expenses from EBITDA.

3. Compute tax by multiplying EBIT by the tax rate.

4. Compute net operating profit after tax (NOPAT) by adding back depreciation and amortisation expenses to EBIT.

5. Compute operating cash flows by adding back depreciation and amortisation expenses to NOPAT.

Take a look at this: How to Calculate Annual Net Cash Flow

6. Subtract capital expenditures and additions to working capital from operating cash flows to get after-tax FCF.

Here's a breakdown of the calculation:

Revenue - Operating Expenses = EBITDA

EBITDA - Depreciation/Amortisation Expenses = EBIT

EBIT x Tax Rate = Tax

EBIT + Depreciation/Amortisation Expenses = NOPAT

NOPAT + Depreciation/Amortisation Expenses = Operating Cash Flows

Operating Cash Flows - Capital Expenditures - Additions to Working Capital = After-tax FCF

Let's consider an example to illustrate this calculation. Radiant Ltd is considering launching a new lighting product that requires an initial investment in machinery and facilities of $300,000. The project is estimated to generate $1,500,000 in annual sales for five years with annual cost of sales (materials and direct labour) of $1,000,000. The project will also require five additional employees in Radiant's sales team, which will increase the company's salaries and wages expenses by $250,000 per year.

If the tax rate is 30%, what is the annual operating cash flow (OCF) for the first year of this project?

A different take: Discount Rate of Cash Flows

Incremental budgeting is crucial in computing relevant cash flows. It involves identifying the cash flows related to the project, excluding those that are not incremental.

To determine incremental capital expenditures, we need to consider the alternative use of existing assets. If the project uses assets the company already owns, the original cost of those assets is a sunk cost – no cash flow is required today.

The alternative use of existing assets can be to rent them out or sell them. In the case of a hotel adding a new restaurant, the existing assets might be kitchen appliances, furniture, and other fixed assets.

The opportunity cost of using existing assets is the next best option for those assets. If the next best option is to sell them, the opportunity cost is the value of the asset in cash today.

Here's a list of key considerations for identifying incremental budgeting:

By considering these factors, we can accurately determine the incremental capital expenditures required for a project. This helps ensure that we're only accounting for the cash flows that are directly related to the project.

Capital budgeting is a process that helps organizations make informed investment decisions by identifying relevant cash flows. The process involves several steps, starting with the identification of various investment proposals.

These proposals can come from top management or lower-ranking employees, and they are analyzed by department heads before being submitted to a planning committee. The planning committee then screens the proposals to match them with the available resources of the concern.

The selected proposals are then evaluated using various methods, such as payback period, net present value, and accounting rate of return. The goal is to determine which proposals will give the greatest profit or economic benefit.

If a proposal is deemed suitable for the concern's financial condition, it is implemented by the competent authority, who assigns responsibilities and timelines to ensure successful completion. Network techniques like PERT and CPM are used to monitor and control the implementation process.

The final stage of capital budgeting involves reviewing the actual results of the project against the standard results, identifying any adverse outcomes, and removing any difficulties that may have arisen. This helps to improve future proposals and ensure that the organization is making the most of its available resources.

Consider reading: Working Capital Cash Flow Statement

NOPAT is computed as EBIT less tax, with tax calculated by multiplying EBIT by the corporate tax rate.

Interest expense is not deducted from EBIT when calculating NOPAT, as it's excluded from the analysis.

The financing expense is incorporated in the discount rate when determining NPV later.

Capital cash flows occur when purchasing or selling fixed assets required for a project.

These cash flows are typically large and occur at the beginning or end of the project.

The initial investment in machinery and facilities for Radiant Ltd's new lighting product was $300,000.

The annual operating cash flow (OCF) for the first year of the project can be calculated by estimating sales, cost of sales, and salaries and wages expenses.

The tax rate for Radiant Ltd is 30%.

The annual OCF for the first year of the project is calculated by subtracting the annual cost of sales and salaries and wages expenses from the annual sales, then multiplying the result by 1 minus the tax rate.

A different take: Annual Net Cash Flow

To calculate the cash flow amount to be included in year zero for Amazing Androids' new retail outlet, you need to consider the investment in working capital.

The working capital investment includes cash float, investment in inventory, increase in accounts payable to suppliers, and increase in accounts receivable from customers.

The total cash flow amount to be included in year zero is the sum of these investments.

A unique perspective: Cash-flow Return on Investment

NPV and IRR analysis are two essential tools for evaluating investment opportunities.

The Net Present Value (NPV) calculation takes into account the time value of money, discounting future cash flows to their present value.

A positive NPV indicates that the investment is expected to generate returns that exceed its costs.

For example, if an investment has a NPV of $10,000, it means that the present value of the expected future cash flows is $10,000 higher than the initial investment.

The Internal Rate of Return (IRR) is the rate at which the NPV equals zero, indicating the minimum return required to break even.

In the case of the investment with a NPV of $10,000, the IRR is the rate at which the present value of the future cash flows equals the initial investment plus $10,000.

A higher IRR is generally preferred, as it indicates a more attractive investment opportunity.

A unique perspective: How to Calculate Present Value Cash Flow