Monday, May 10, 2010


Component of Cash Flows

Annual net cash flows

An investment is expected to generate annual cash flows from operations after the initial cash outlay has been made. Cash flows should always be estimated on an after tax basis. Some people advocate computing of cash flows before tax basis and discounting them at the before-tax discount rate to find net present value (NPV). Unfortunately, this will not work in practice since there does not exist an easy and meaningful way for adjusting the discount rate on a before-tax basis.

We shall refer to the after-tax cash flows as net cash flows (NCF) and use the terms C1, C2, C3…….Cn respectively for NCF in period 1, 2, 3………n. NCF is simply the difference between cash receipts and cash payments including taxes. NCF will mostly consists of annual cash flows occurring from the operation of an investment, but it is also be affected by changes in net working capital and capital expenditures during the life of the investment. To illustrate, we first take the simple case where cash flows occur only from operations. Let us assume that all revenues (sales) are received in cash and all expenses are paid in cash (obviously cash expenses will exclude depreciation since it is a non-cash expense). Thus, the definition of NCF will be:

Net cash flow = Revenue – Expense – Taxes


Notice that in equation taxes are deducted for calculating the after-tax cash flows. Taxes are computed on the accounting profit, which treats depreciation as a deductible expense.

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