Construction of Cash Flows Revisited
29 Pages Posted: 24 Aug 2005
Date Written: August 2005
Usually a great deal of effort is devoted in typical financial textbooks to the mechanics of the calculations of time value of money equivalencies: payments, future values, present values, etc. This is necessary. However little or no effort is devoted to how to arrive at the figures required to calculate the Net Present Value NPV or Internal Rate of Return, IRR. In the paper, pro forma financial statements (Balance Sheet (BS), Income Statement (IS) and Cash Budget (CB) are presented. From the CB, the Free Cash Flow FCF, the Cash Flow to Equity CFE, the Cash Flow to Debt CFD and the Capital Cash Flow are derived. Also, the FCF and the CFE are calculated with the typical approach found in the literature: from the IS and it is specified how to construct them. In doing this, working capital is redefined: the result is that it has to include some items that are not taken into account in the traditional methods.
An example is presented to illustrate the procedure to calculate the cash flows. In the Appendixes we show how to arrive to the levered equity and firm value.
Keywords: Free cash flow, cash flow to equity, cash flow to debt, project evaluation, firm valuation, investment valuation, Net Present Value NPV
JEL Classification: D92, E22, E31, G31
Suggested Citation: Suggested Citation