Cash flows

B- Defining future benefits from ownership of financial assets.

Future benefits that need to be included in the general formula, are all forms of changes in owner's wealth attributable to ownership of a given financial asset. Often much effort is put into writing precisely what the owner is entitled to. In the case of a loan, lender's rights are spelled out in a loan contract where interest and principal are promised to be paid at predetermined dates and in unambiguous amounts. For bonds, coupons and principal are also clear cut. But many bonds are made attractive to potential buyers with a variety of inducements (i.e. sweeteners) such as conversion right, redemption right, call or put option, and so on (see Chapter 12 Section D-3). Quantifying their monetary value is an added challenge. In the case of stocks, a right to dividends bears no guarantee; likewise, any expected increase in stock price in the market is dependent on a wide range of company, market, economic and even political developments.

For other types of investment, such as in new equipment or merging with a another company, outcomes are subject to forces even more difficult to predict. Most of this manual is precisely devoted to an analysis of these forces. But rather than dissect each different possible benefit separately at this time, it is useful to establish some general principle that apply to all financial assets. To this end, in the following paragraphs, the wording used will be applicable to all types of financial assets, including an investment in a company project, and is, thus, borrowed from the context of capital budgeting.

The rule is that future benefits must be anything that pertains to the decision at hand, and that changes the wealth of the decision maker. Thus, these benefits should be all relevant net after tax incremental cash flows or cash flow equivalents. Let's take each element one by one.

- Changes in wealth: this is any form of revenue such as dividends for stocks, coupon payments for bonds, installment payments for loans and revenues from sale of products or assets.

- Relevant: only what is relevant should be taken into account, and that is what has a direct bearing on the decision. Naturally, this depends on the range of opportunities. For instance, a plant manager is choosing between two new lathes that must replace an old lathe. Should the salvage value of the old lathe enter into consideration? The answer is no, as long as replacing the old machinery is not brought back into question. What to do with the old lathe has no bearing on the choice between new machines.

- Net: expenses directly related to revenues must be deducted. For the lathe replacement, that would be freight, installation, insurance, upkeep and maintenance of the new lathe. For securities, that should be all costs of acquisition, as well as collection of benefits; these costs should theoretically include costs of research and transaction (which are known as friction costs). In practice, such friction costs are hardly ever incorporated in stock or bond calculation. For loans, these costs are not netted against installment payments, but are embedded in interest rate, as will be shown in Chapter 3 Section C.

- After tax: taxes must also be deducted because a person's wealth is net of tax. Yet, often this requirement is also not taken into account for securities because calculations are not conducted for a specific investor, but for any potential owner, and each owner is likely to be in a different tax bracket. In capital budgeting, projects are compared taking the marginal tax rate of the firm if the project expands sales and profits, and the average tax rate if the project replaces an existing process and does not increase sales or profits.

- Incremental: only increases in benefits and costs pertaining directly to the decision should be included. What is not incremental, i.e. what would not change, is not relevant. Generally speaking all fixed costs and costs pertaining to the past are to be omitted from calculation. The latter are sunk costs and nothing can be done about them.

- Cash flow: the benefit is not profit but cash flow because profit includes accruals, deferrals and fixed overhead that are not all relevant to the decision at hand. Most typically, for instance, depreciation, depletion and amortization are deducted in arriving at profit, but these do not constitute an actual cash payment in the year they are recorded (instead, in some previous year when the asset was acquired). They must be added back if they have been initially deducted as expense. Note, however, that the tax calculation must retain depreciation (and the like) as expense to account for the tax saving that it generates. Thus, there are two methods of calculating cash flows: either profit after tax plus depreciation added back, or after tax net cash revenues less cash expenses, and minus tax saving from depreciation. The first method is more commonly used.

- Cash flow equivalent: depreciation is also a good example of a cash flow equivalent. But there are many others that produce a saving in expenses, or a right to some future cash flow. A typical example is a conversion right attached to a bond: the potential for owning stock must be quantified based on the market stock price, even if the bondholder has no intention to exercise the conversion right at the present time.

1)- Adjusting for inflation or not

There are two approaches to dealing with inflation: a) include it in both cash flow determination and discount rate, or b) omit it from both. One may note that in defining future benefits as cash flows, nothing is said about inflation. There is an implied assumption that all future amounts of revenue and expense are stated in today currency, i.e. all amounts are real amounts unaffected by inflation. This is where a distinction must be made between valuation of projects in capital budgeting and valuation of other financial assets. For most financial assets, the future cash flows such as coupons, loan installments, dividends, and the like, are naturally the actual dollar amounts to be received. These are nominal amounts, conversion to real (i.e. inflation deflated) cash flows does not make sense, and the only choice is to use nominal rates.

In the case of capital projects, an assumption of ingnoring inflation is often be difficult to accept because inflation is known to be present in every economy of the world, and severe inflation is present in a few. In practice, rejecting the assumption in capital budgeting and adjusting each cash flow for future inflation creates more problems than it is worth. If all future amounts are to be adjusted for inflation, i.e. inflated, an inflation rate needs to be forecasted; and the projected inflation rate that most analysts would usually accept would be the current rate of inflation. For countries where inflation projections would seem most necessary, are naturally those where inflation has been high for some time. But, inflation is especially unstable in such countries. Thus, putting into the calculation, any estimate of future inflation that is known to be inaccurate, appears, in the end analysis, to bring more distortion than omitting it altogether.

When inflation is ignored (as just recommended), but actually takes place, the only significant distortion will consist of an overstatement of depreciation. Indeed, in actual future income statements, depreciation is calculated using original purchase price, but is deducted from revenues which are stated in inflated currency; that means that the actual tax saving from depreciation decreases with inflation. Whereas, when real cash flows are estimated, the tax saving from depreciation remains constant and is therefore overstated in the capital budgeting process. There is some relief for this distortion in the countries where inflation is very high because, in those countries, accounting rules allow reevaluation of assets, and therefore depreciation, using an officially announced index of inflation.

To reconcile the valuation of capital budget projects with valuation of other financial assets, the procedure is, thus, to use nominal rates in discounting nominal amounts, and to use real rates in discounting real amounts. This will be further discussed in the section describing the components of interest rates.

2)- Irrelevance of prior years

Value of all things stems from the utility it offers for the future and not from any past costs incurred in producing or acquiring it. The price for which an asset was acquired, and which is shown on the balance sheet, has little to do with its actual future use. Take, for instance, the case of a bread factory: whether its ovens were purchased in 1989, for 1,000,000 rubles, or in 1994, for 100,000,000 rubles, does not matter as long as they work. What matters is for employees to bake a bread of such high quality and in such quantity that customers will want to buy it all. Book values do not matter. Future sales and profits are what must be considered regardless of what is shown on the balance sheet.

For the same reason, generally speaking, balance sheet amounts are mostly irrelevant when comparing the ability of various companies to exploit sales opportunities at their disposal. Yet, balance sheet amounts will naturally be scrutinized in Chapters 10 through 12. But their analysis will also be conducted keeping an eye toward the future, to determine company's ability to produce enough for its planned sales. In addition, the inquiry may focus on how efficiently balance sheet assets are utilized, or whether the depreciation method generates sufficient cash flows for that equipment to be replaced in due time. In other words, value does not come from owning an asset (e.g. an oven), but from its future use (i.e. future sales).

3)- Impact of available range of opportunities

Thus, the challenge is in forecasting future events. Let's investigate this with a simplistic example from our personal lives. Take some personal item, such as a pair of winter mittens, for instance. The value of these mittens is determined by the opportunity to keep fingers warm in cold weather. First, the mittens can be compared to other personal possessions, such as driving gloves, a scarf and a range of other such items. From that comparison, one will decide if greater utility is perceived to be derived from the purchase and ownership of the $15 mittens than from a $15 shirt or scarf. Second, the opportunity to actually use the mittens in the future will dictate whether one should buy and keep the mittens, or on the contrary, sell them or never buy them. If one plans to move to a northern country, benefits from warm mittens will appear more tangible and value could go up to some $50 (e.g. cost of an air freight special delivery). But, if one anticipates moving to an equatorial country where there would be no need for mittens, their value would sink to $1 or possibly some negative value for cost of disposal.

Opportunity must also be seen from the angle of multiple users: for instance, a rental of the mittens to a cousin on excursion to an Alpine retreat in exchange for a bottle of good beer, gives another measurement of alternative benefits. In fact, the process of valuation by studying rental opportunities is commonly practiced in real estate. For instance, one could assign a value of $24 for 24 mitten rental opportunities.

In all these different view points of opportunity valuation, any initial purchase price has little significance. In general, the initial purchase price of an item is only relevant if a) the price itself does not change, and b) the item is not affected by technological change. In today's world of fast paced technological progress to serve customers ever better, rare are items for which these conditions are met. Even items as basic and unchanging as salt or sugar have recently experienced decreasing prices because health-conscious consumers lost their taste for them. What does not enjoy an increasing demand has a decreasing value.

Left for us to examine is the selling price of the asset, it is certainly an opportunity worth considering. But the new element to consider is the fact that the set of opportunities of any potential purchaser must now be brought into the picture, and these opportunities are likely to be further discounted or rebated (i.e. reduced in value) because the potential purchaser is not sure whether or not defects are present in the asset(e.g. the mittens of our previous example). Both, selling prices and buying prices (also known for financial assets as asked and bid prices, respectively) are affected by the structure and breadth of the market, and the type of participants in it. An insufficient number of buyers or sellers will cause mispricing. To overcome such deficiencies, buyers must gather information, and sellers must distribute information (through advertisement or other techniques). Information gathering and dissemination add to transaction costs.

Many product markets and financial markets in Russia are notoriously underdeveloped and inefficient. For instance, sellers of securities can be standing next to subway exits alongside banana and apple vendors. A general distrust also exists for many forms of publicity. Financial claims especially are judged with skepticism after several scams ruined a large number of individuals. Obtaining reliable information about Russian companies is also difficult.

Much more will be said about cash flow measurement in next chapter and Chapter 10.

See review questions Q-2B.1 through Q-2B3.3.

See research assignment R-2B.1.

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Last modified: Jun/01/01 Next: Discounting