Session 15: Investment Returns II - Getting to Time Weighted Cash Flows

Summary

In this corporate finance session, the instructor explains the transition from accounting earnings to cash flows and the process of calculating incremental cash flows and time-weighted returns. The importance of distinguishing between sunk costs and incremental cash flows is emphasized, along with the role of depreciation, capital expenditures, and working capital in shaping the project’s financial landscape. The session also covers essential financial metrics like Net Present Value (NPV) and Internal Rate of Return (IRR), illustrating how these measures help evaluate investment opportunities. Ultimately, the session underscores the practical application of these concepts to assess long-term project value and investment viability.

Takeaways

• 😀 The process of evaluating investment returns involves transitioning from accounting earnings to cash flows, and then to time-weighted incremental cash flow returns.
• 😀 Cash flows are preferred over accounting earnings in investment analysis because they better represent the actual economic impact of a project.
• 😀 Depreciation and amortization are added back to cash flows since they reduce taxable income, offering tax savings, even though they are subtracted in the accounting earnings calculation.
• 😀 Sunk costs, such as prior investments already made, should be excluded from the investment decision-making process, as they cannot be recovered.
• 😀 Non-incremental costs, like certain allocated general and administrative (GNA) expenses, should be ignored when calculating incremental cash flows since they remain unchanged regardless of the investment decision.
• 😀 Incremental cash flows are the key focus in investment decision-making, and adjustments for sunk costs and non-incremental expenses are necessary to accurately estimate them.
• 😀 Time-weighting cash flows involves discounting future cash flows, as the further in the future they occur, the less value they have in present terms.
• 😀 Five types of cash flows are common in financial analysis: simple cash flows, annuities, growing annuities, perpetuities, and growing perpetuities, each with its own present value formula.
• 😀 Net Present Value (NPV) is a measure of incremental cash flow return that sums the present values of all cash flows, and a positive NPV indicates a good project.
• 😀 Internal Rate of Return (IRR) is the discount rate that makes the NPV of a project equal to zero, and comparing IRR to the cost of capital helps assess the investment's viability.
• 😀 The NPV and IRR methods are both time-weighted, incremental cash flow measures, and although they may have differences in certain cases, they generally lead to the same conclusion when used for project evaluation.

Q & A

What is the primary focus of this session in the corporate finance class?

The primary focus of this session is to discuss the process of going from earnings to cash flows, then to incremental cash flows, and finally to time-weighted, incremental cash flow returns in order to measure investment returns on a project.

Why is cash flow considered better than accounting earnings in measuring investment returns?

Cash flow is considered better than accounting earnings because it provides a more accurate reflection of a project's financial performance by accounting for actual cash generated, rather than relying on accounting measures that may include non-cash items.

What adjustments are made to accounting earnings to arrive at cash flows?

To convert accounting earnings to cash flows, depreciation and amortization are added back, capital expenditures are subtracted, and changes in working capital are accounted for.

What is a sunk cost, and why is it ignored in investment decisions?

A sunk cost is money already spent that cannot be recovered if the project is rejected. It is ignored in investment decisions because it has no impact on the future cash flows of the project.

How is the allocation of General & Administrative (GNA) expenses handled when calculating incremental cash flows?

Allocated GNA expenses are treated as non-incremental because they would occur regardless of whether the project is accepted. Only the after-tax portion of GNA that is truly incremental is considered in the calculation.

What is the significance of time-weighting incremental cash flows in investment analysis?

Time-weighting incremental cash flows, which is essentially discounting future cash flows, is important because it reflects the principle that the value of money decreases over time. The further in the future a cash flow occurs, the more it is discounted.

What are the five types of cash flows encountered in finance, and how are their present values calculated?

The five types of cash flows are: simple cash flows, annuities, growing annuities, perpetuities, and growing perpetuities. Present values are calculated using formulas involving the discount rate and the time at which the cash flow occurs.

What is the difference between net present value (NPV) and internal rate of return (IRR)?

NPV is the sum of the present values of a project's cash flows, indicating the absolute value added to the business. IRR is the discount rate that makes the NPV equal to zero, representing the percentage return on investment. Both are used to assess project profitability, with NPV providing a dollar amount and IRR providing a percentage.

Why is the terminal value used in the theme park example, and how is it calculated?

The terminal value is used to estimate the value of the project beyond the evaluation period, accounting for ongoing cash flows that will continue growing at an inflation rate. It is calculated by assuming cash flows will grow at a constant rate forever, then discounting them to the present using the cost of capital.

What are the challenges of using IRR in investment decisions, and when might multiple IRRs occur?

IRR can be challenging because it assumes that intermediate cash flows are reinvested at the IRR, which may not always be realistic. Multiple IRRs may occur when cash flows change signs multiple times during the project's life, making it harder to interpret the IRR correctly.