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2. Firms that sell goods and services on credit can reduce their net working capital needs
by inducing customers to pay their bills faster, and by improving their collection
3. Firms can also look for suppliers who offer more generous credit terms since
accounts payable can be used to finance inventory and accounts receivable.
4. Firms that need cash for operational reasons can reduce their net working capital by
keeping this cash balance to its minimum.


From Accounting Earnings to Cashflows
The three factors outlined above can cause accounting earnings to deviate
significantly from the cash flows. To get from after-tax operating earnings, which
measures the earnings to the firm, to cash flows to all investors in the firm, we have to
Add back all non-cash charges, such as depreciation and amortization, to the

operating earnings
Subtract out all cash outflows that represent capital expenditures

Net out the effect of changes in non-cash working capital, i.e. changes in accounts

receivable, inventory and accounts payable. If non-cash working capital increased,
the cash flows will be reduced by the change, whereas if it decreased, there is a cash
The first two adjustments adjust operating earnings to account for the distinction drawn
by accountants between operating and capital expenditures, whereas the last adjustment
converts accrual revenues and expenses into cash revenues and expenses.
Cash Flow to Firm = Earnings before interest and taxes (1-t) + Depreciation &
Amortization - Change in Non-cash Working Capital - Capital Expenditures
The cash flow to the firm is a pre-debt, after-tax cash flow that measures the cash
generated by a project for all claim holders in the firm, after reinvestment needs have
been met.
To get from net income, which measures the earnings of equity investors in the
firm, to cash flows to equity investors requires the additional step of considering the net
cash flow created by repaying old debt and taking on new debt. The difference between
new debt issues and debt repayments is called the net debt, and it has to be added back to
arrive at cash flows to equity. In addition, other cash flows to non-equity claim holders in
the firm, such as preferred dividends, have to be netted from cash flows.
Cash Flow to Equity = Net Income + Depreciation & Amortization - Change in Non-cash
Working Capital - Capital Expenditures + (New Debt Issues “ Debt Repayments) “
Preferred Dividends
The cash flow to equity measures the cash flows generated by a project for equity
investors in the firm, after taxes, debt payments and reinvestment needs.


5.2. ˜: Earnings and Cash Flows
If the earnings for a firm are positive, the cash flows will also be positive.
a. True
b. False
Why or why not?

In Practice: Managing Earnings
Companies, which have seen the effect on their stock prices of not meeting
analyst expectations on earnings, have learned over the last decade to manage their
earnings. Accounting standards, strict as they are for U.S. companies, still allow some
leeway for firms to move earnings across periods by delaying revenues or expenses, or
choosing a different accounting method. Companies like Microsoft not only work at
holding down expectations on the part of analysts following them, but also use their
growth and flexibility to move earnings across time to beat expectations. In January
1997, Microsoft reported earnings per share of 57 cents for the quarter, beating consensus
estimates of 51 cents per quarter, the 41st quarter out of 42 that Microsoft had beaten
The phenomenon of managing earnings has profound implications for a number
of actions that firms may take, from how they sell their products and services, to what
kinds of projects they take or firms they acquire and how they account for such
investments. While Microsoft has not been guilty of accounting manipulation and has
worked strictly within the rules of the game, other companies which have tried to
replicate its success have had to resort to far more questionable methods to report
earnings that beat expectations.

The Case for Cash Flows
When earnings and cash flows are different, as they are for many projects, we
must examine which one provides a more reliable measure of performance. We would
argue that accounting earnings, especially at the equity level (net income), can be
manipulated at least for individual periods, through the use of creative accounting
techniques and strategic allocations. In a book, entitled Accounting for Growth which


won national headlines in the United Kingdom and cost the author his job, Terry Smith,
an analyst at UBS Phillips & Drew, examined 12 legal accounting techniques commonly
used to mislead investors about the profitability of individual firms. To show how
creative accounting techniques can increase reported profits, Smith highlighted such
companies as Maxwell Communications and Polly Peck, both of which eventually
succumbed to bankruptcy.
The second reason for using cash flow is a much more direct one. No business
that we know off accepts earnings as payment for goods and services delivered; all of
them require cash. Thus, a project with positive earnings and negative cash flows will
drain cash from the business undertaking it. Conversely, a project with negative earnings
and positive cash flows might make the accounting bottom line look worse, but will
generate cash for the business undertaking it.

B. Total versus Incremental Cash Flows
The objective when analyzing a project is to answer the question: Will taking this
project make the entire firm or business more valuable? Consequently, the cash flows we
should look at in investment analysis are the cash flows the project creates for the firm or
business considering it. We will call these cash flows incremental cash flows.

Differences between Incremental and Total Cashflows
The total and the incremental cash flows on a project will generally be different
for two reasons. The first is that some of the cash flows on an investment may have
occurred already and therefore are unaffected by whether we take the investment or not.
Such cash flows are titled sunk costs and should be removed from the analysis. The
second is that some of the projected cash flows on any investment will be generated by
the firm, whether this investment is accepted or rejected. Allocations of fixed expenses,
such as general and administrative costs, usually fall into this category. These cash flows
are not incremental and the analysis needs to be cleansed of their impact.

1. Sunk Costs
There are some expenses, related to a project that might be incurred before the
project analysis is done. One example would be expenses associated with a test market
done to assess the potential market for a product prior to conducting a full-blown


investment analysis. Such expenses are called sunk costs. Since they will not be
recovered if the project is rejected, sunk costs are not incremental and therefore should
not be considered as part of the investment analysis. This contrasts with their treatment in
accounting statements, that do not distinguish between expenses that have already been
incurred and expenses which are still to be incurred.
One category of expenses that consistently falls into the sunk cost column in
project analysis is research and development, which occurs well before a product is even
considered for introduction. Firms that spend large amounts on research and
development, such as Merck and Intel, have struggled to come to terms with the fact that
the analysis of these expenses generally occur after the fact, when little can be done about

In Practice: Who Will Pay The Sunk Costs?
While sunk costs should not be treated as part of investment analysis, a firm does
need to cover its sunk costs over time or it will cease to exist. Consider, for example, a
firm like McDonald™s, which expends considerable resources in test marketing products
before introducing them. Assume, on the ill-fated McLean Deluxe (the low-fat
hamburger introduced in 1990), that the test market expenses amounted to $30 million
and that the net present value of the project, analyzed after the test market, amounted to $
20 million. The project should be taken. If this is the pattern for every project
McDonald™s takes on, however, it will collapse under the weight of its test marketing
expenses. To be successful, the cumulated net present value of its successful projects will
have to exceed the cumulated test marketing expenses on both its successful and
unsuccessful products.

2. Allocated Costs
An accounting device created to ensure that every part of a business bears its fair
share of costs is allocation, whereby costs that are not directly traceable to revenues
generated by individual products or divisions are allocated across these units, based upon
revenues, profits, or assets. While the purposes of such allocations may be rational, their
effect on investment analyses have to be viewed in terms of whether they create


“incremental” cash flows. An allocated cost that will exist with or without the project
being analyzed does not belong in the investment analysis.
Any increase in administrative or staff costs that can be traced to the project is an
incremental cost and belongs in the analysis. One way to estimate the incremental
component of these costs is to break them down on the basis of whether they are fixed or
variable, and, if they are variable, what they are a function of. Thus, a portion of
administrative costs may be related to revenue, and the revenue projections of a new
project can be used to estimate the administrative costs to be assigned to it.

Illustration 5.3: Dealing with Allocated Costs
Case 1: Assume that you are analyzing a project for a retail firm with general and
administrative (G&A) costs currently of $600,000 a year. The firm currently has five
stores, and the new project will create a sixth division. The G & A Costs are allocated
evenly across the stores; with five stores, the allocation to each store will be $120,000.
The firm is considering opening a new store; with six stores, the allocation of G & A
expenses to each store will be $100,000.
In this case, assigning a cost of $100,000 for general and administrative costs to the
new store in the investment analysis would be a mistake, since it is not an incremental
cost ““ the total G& A cost will be $600,000, whether the project is taken or not.
Case 2: In the analysis above, assume that all the facts remain unchanged except for one.
The total general and administrative costs are expected to increase from $600,000 to
$660,000 as a consequence of the new store. Each store is still allocated an equal amount;
the new store will be allocated one-sixth of the total costs, or $110,000.
In this case, the allocated cost of $110,000 should not be considered in the investment
analysis for the new store. The incremental cost of $ 60,000 [$660,000-$600,000],
however, should be considered as part of the analysis.
In Practice: Who Will Pay For Headquarters?
As in the case of sunk costs, the right thing to do in project analysis (i.e.,
considering only direct incremental costs) may not add up to create a firm that is
financially healthy. Thus, if a company like Disney does not require individual movies
that it analyzes to cover the allocated costs of general administrative expenses of the


movie division, it is difficult to see how these costs will be covered at the level of the
In 2003, Disney™s corporate shared costs amounted to $443 million. Assuming
that these general administrative costs serve a purpose, which otherwise would have to be
borne by each of Disney™s business, and that there is a positive relationship between the
magnitude of these costs and revenues, it seems reasonable to argue that the firm should
estimate a fixed charge for these costs that every new investment has to cover, even
though this cost may not occur immediately or as a direct consequence of the new

The Argument for Incremental Cash Flows
When analyzing investments it is easy to get tunnel vision and focus on the
project or investment at hand, and to act as if the objective of the exercise is to maximize
the value of the individual investment. There is also the tendency, with perfect hindsight,
to require projects to cover all costs that they have generated for the firm, even if such
costs will not be recovered by rejecting the project. The objective in investment analysis
is to maximize the value of the business or firm taking the investment. Consequently, it is
the cash flows that an investment will add on in the future to the business, i.e, the
incremental cash flows, that we should focus on.

Illustration 5.4: Estimating Cash Flows for an On-line Book Ordering Service:
As described in illustration 5.1, Bookscape is considering an on-line book
ordering and information service, which will be staffed by two full-time employees. The
following estimates relate to the costs of starting the service and the subsequent revenues
from it:
1. The initial investment needed to start the service, including the installation of
additional phone lines and computer equipment, will be $ 1 million. These
investments are expected to have a life of 4 years, at which point they will have no
salvage value. The investments will be depreciated straight line over the 4-year life.
2. The revenues in the first year are expected to be $ 1.5 million, growing 20% in year 2,
and 10% in the two years following.


3. The salaries and other benefits for the employees is estimated to be $150,000 in year
1, and grow 10% a year for the following 3 years.
4. The cost of the books is assumed to be 60% of the revenues in each of the 4 years.
5. The working capital, which includes the inventory of books needed for the service
and the accounts receivable (associated with selling books on credit) is expected to
amount to 10% of the revenues; the investments in working capital have to be made
at the beginning of each year. At the end of year 4, the entire working capital is
assumed to be salvaged.
6. The tax rate on income is expected to be 40%, which is also the marginal tax rate for
Based upon this information, we estimate the operating income for Bookscape Online in
table 5.2:
Table 5.2: Expected Operating Income on Bookscape Online
1 2 3 4
Revenues $1,500,000 $1,800,000 $1,980,000 $2,178,000
Operating Expenses
Labor $150,000 $165,000 $181,500 $199,650
Materials $900,000 $1,080,000 $1,188,000 $1,306,800
Depreciation $250,000 $250,000 $250,000 $250,000
Operating Income $200,000 $305,000 $360,500 $421,550
Taxes $80,000 $122,000 $144,200 $168,620
After-tax Operating Income $120,000 $183,000 $216,300 $252,930

To get from operating income to cash flows, we add back the depreciation charges and
subtract out the working capital requirements (which are the changes in working capital
from year to year). We also show the initial investment of $ 1 million as a cash outflow


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