Cash Flows (Week 5)

Question 1

What is capital budgeting?

Answer 1

The process through whcih firms analyse alternative projects and decide which ones to pursue.

Question 2

What are the two main challenges of capital budgeting?

Answer 2

1. Obtain a cost of capital that is specific to the project and reflect project’s risk and type of financing (debt, cash or equity).
2. Obtain the project cash flows

Question 3

What are earnings?

Answer 3

Excess of revenues over direct expenses for a given period. It is an accounting measure used to determine tax obligations.

Question 4

How do cash flows and earnings differ?

Answer 4

Earnings are an accounting measure to determine tax obligations. Cash flows are a finance measure used to determine the value of an investment.

Question 5

Three reasons why earnings do not equal cash flows?

Answer 5

1. Accrual accounting: revenues and associated expenses are recognised when a sale is made not when the money is received (or paid)
2. Inventory and receivables build ups (draw downs) use (generate) cash
3. Depreciation is not a cash outflow

Question 6

How do you calculate a project’s Free Cash Flow?

Answer 6

By taking the after-tax operating profit from the income statement and undoing all accounting distortions.

FCF= EBIT - Taxes + Depreciation - Capital Expenditure - Change in NWC

Question 7

How do you calculate Net Working Capital (NWC)?

Answer 7

NWC = Inventory + Cash Requirements + Receivables - Payables

The “working capital” needed to run the business