CNV Krishnan
Weatherhead School of Management
1
Notes on Cash Flows and “Free” Cash Flows
Cash Flow from Assets (CFA)
(With reference to the simple balance sheet we used in class)
Earnings before interest payable and taxes (EBIT)
- Taxes
+ Depreciation
- Increase in Accounts Receivable
- Increase in Inventory
- Increase in cash balance
(marketable securities balances, actually, because the firm would likely have
invested cash balances in short term securities)
- Investment in Fixed assets (net capital spending: computed as the change in the
net fixed asset numbers in the balance sheet from last year end to this year end +
depreciation for this year)
+ Increase in accounts payable
( “non-interest” liability: liability not associated with either the shareholders or
debt holders)
_____________
= CFA
That is, increases in all assets are uses of funds while increases in the non-interest
liabilities are sources of funds.
CFA is a cash flow measure of the value generated by the firm in that year. However
it is dependant on the debt-equity ratio (capital structure) of the firm as well as the
dividend policy (payout policy) of the firm.
If the firm has adequate unsheltered taxable income, increasing debt increases
interest and lowers taxes. This is because interest payable is deducted from EBIT
before taxes are calculated. The amount by which interest expense reduces taxes is
called the Interest Tax Shield (ITS), where
ITS = Interest x corporate tax rate = I x TC
As taxes reduce, the cash flows available to the shareholders and debtholders
increase. So having more debt on the capital structure increases cash flows to the
shareholders and debtholders in the current period, but in ...