Question

• Estimating firm’s FCF and Cash Flow Statement is important.

  • The increases in cash & equivalents along with marketable securities is not equal to retained earnings. In addition, after-tax CFs generated by a firm for its investors from its underlying business activities (FCFs) are not equal to NOPAT, the income generated by the firm for all its investors. Explain the underlying accounting principles that lead to this conclusion.

  • What is net operating working capital? Why does it exclude most short-term investments and notes payable? What is total net operating capital? Why is it important for managers to calculate a company’s capital requirements?
    

• Mutually exclusive projects can be evaluated using various measures (metrics), three of which are NPV, IRR, and Payback period.

  • Describe what each metric is calculating using the simplest possible words.

  • Why is NPV the primary capital budgeting decision metric for mutually exclusive projects? Explain.

  • In which situations do the other metrics (IRR and Payback) fail to maximize stockholder wealth if projects are mutually exclusive? Explain why.

Answer 1

Free Cash flow(FCF) refers to the cash and cash equivalents that the firm has available for distribution to the owners of the company .In order to arrive or compute the Free Cash flow we start with net income which is found in the income statement the other components used are interest expense non cash expense , change in working capital(found in balance sheet) and Capital expenditures(found in the balance sheet)Capital expenditures refer to the long term investments that the firm has made like purchase of land plant machinery etc.Change in working capital is the change in current assets and current liabilities that occur over the present and past periods)The formula is as follows:Net Income +Non Cash expense+/- change in working working capital-Capital expenditures.FCF helps provide an estimate of the cash that a business generates from it's capital expenditures.

NOPAT(Net Operating profit After Tax) refers to the amount we arrive after taking into consideration revenue COGS fixed expenses interest and tax rate.the formula for NOPAT) is Net income +tax +Interest +Non operating gain /loss)*(1-tax rate).NOPAT provides an estimate of the companies income and facilitates comparison between companies.

Net operating working capital refers to the difference between operating current assets and operating current liabilities.It is a part of the FCF calculation. Items like notes payable and short term investments are excluded since they are interest bearing.Net operating working Capital is used to analyze the liquidity of the firm.

total net operating capital refers to all the current and non current assets used by a business in it's operations and is apart of FCF calculation.the formula is as follows:Net Operating working capital +non operating current assets

It is important for managers to calculate the capital requirements(working capital) since that is essential or the financial well being of the firm.it would give managers an idea about the short term cash requirements needed for day to day operations of the business and overall smooth functioning of the business.

NPV(Net Present Value) It's the total present values of future inflows of a firm minus the initial outflow.its used to assess the viability of a project.It helps a firm to estimate the value a project would add to it.Generally projects with a positive NPV are accepted.

Payback period is another technique used for investment proposal evaluations and is used to determine the time period required by a project o recover it's cost.

IRR(internal rate Of Return) is the discount rate at which the Net Present Value =0.It is used to rank projects based on their IRR's.project's with IRR greater than cost of capital are accepted.

When it comes to mutually exclusive projects the NPV method is used as the primary criteria becuase of a few reasons.First ,the NPV method assumes that the cash inflows are reinvested at the required rate of return which is realistic.Secondly the NPv method is more suited because it can still be effectively used even when the required rate of return varies over the life of the project.NPV is also preferred over IRR since it is more reliable when it comes to evaluating investment proposals with several alternating periods of inflows and outflows because it can lead to maximizing share holder wealth

The IRR method makes an assumption tha the inflows from the project are reinvested ta the IRR itself which is unrealistic.Also if the required rate of return varies over the life of project IRR cannot be used as there is no fixed point of reference based on which the IRR ranking can be done.When there are several alternating periods of inflows and outflows IRR cannot be used due o lack of reliability and thereby fails to maxizise shareholder wealth.the Payback period doe not take into consideration the time value o money .It ignores cash flows that occur after payback period ,does not provide a measure of profitability and promotes acceptance of short term projects if the payback period is too short.These are the situations in which the IRR and payback methods fail to maximize shareholder wealth.