Saturday, May 22, 2010


Component of Net Annual Cash Flows
  • Free cash flows

In addition to an initial cash outlay, an investment project may require some reinvestment of cash flow

For example, replacement investment for maintaining its revenue-generating ability during its life

As a consequence, net cash flow will be reduced by cash outflow for additional capital expenditures (CAPEX). Thus, net cash flow will be equal to: after tax operating income plus depreciation minus (plus) increase (decrease) in net working capital and minus capital expenditure:

NCF = EBIT (1 – T) + DEP – NWC – CAPEX

Net cash flows as defined as defined by above equation are called free cash flow (FCF). It is the cash flow available to service both lenders and shareholders, who have provided, respectively, debt and equity, funds to finance the firm’s investments. It is this cash flow, which should be discounted to find out an investment’s net present value (NPV).

Above equation provides the most valid definition of free cash flows or net cash flow. Since net cash flows are stated on incremental basis in investment analysis, that equation may be rewritten as follows:

FCF = delta EBIT (1 – T) + delta DEP – delta NWC – delta CAPEX

Where delta indicates change (increase or decrease)

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