Earnings_versus_Cash_Flow

Earnings_versus_Cash_Flow - Valuation Earnings versus Cash...

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Valuation: Earnings versus Cash Flow Why are we interested in cash flow? The intrinsic value of an investment should not be calculated as the present value of expected future earnings. Earnings do not represent the future cash flows on the investment and it is cash that should be valued. The difference between earnings and cash flows arise from two sources. Adding to cash flow from earnings are any non-cash expenses such as depreciation, deferred tax expenses, bad debt provisions, and goodwill amortization. Subtracting from cash flow from earnings are reinvestment of earnings into the business. The tables below illustrate both issues. The data in the first worksheet shows an investment that costs $1,200, is depreciated using straight-line depreciation, and has a level operating income (after-tax) of $240. Adding depreciation back to net operating income results in a level Free Cash Flow amount of $640 per year. Finally, the assumed capital cost is 10%. Now assume that the project has been initiated. You are standing at Year 0 and wish to earn a yearly rate of return of 10%. What is the maximum price you would be willing to pay? Cost of Capital 10% Year 0 1 2 3 Cost -$1,200.0 Beginning Book Value $0.0 $1,200.0 $800.0 $400.0 Plus Additions $0.0 $0.0 $0.0 Minus Depreciation -$400.0 -$400.0 -$400.0 Ending Book Value $800.0 $400.0 $0.0 Sales $2,000.0 $2,000.0 $2,000.0 Cash Operating Costs -$1,200.0 -$1,200.0 -$1,200.0 Depreciation -$400.0 -$400.0 -$400.0 Pre-Tax Operating Income $400.0 $400.0 $400.0 Taxes at 40%
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Earnings_versus_Cash_Flow - Valuation Earnings versus Cash...

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