Learning ObjectivesUpon completion of Chapter 6 you will b.docx

Learning Objectives
Upon completion of Chapter 6 you will be able to:
• Understand the importance of incremental after-tax cash
flows.
• Be able to estimate incremental after-tax cash flows.
• Be able to calculate the tax consequences on an asset sale.
• Understand why sunk costs do not matter in capital budgeting.
• Know the three categories of cash flows typically seen in an
investment proposal.
Relevant Cash Flows for
Capital Budgeting
6
iStockphoto/Thinkstock
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CHAPTER 6Section 6.1 How to Compute Cash Flows
A company’s very first goal is staying financially healthy; a
bankrupt company helps no one, neither owners nor employees
nor customers. Financial health requires that bills and debts be

paid in full and on time. This is done with cash. Cash
is what lets a company keep its doors open and the lights on.
Cash keeps the machines
running, the raw materials flowing into factories, and the
finished goods flowing out.
In Chapter 2 we explained why cash flow is more important
than accounting profits. We
repeat that message here because it is so important. A company
cannot pay its employ-
ees, suppliers, banks, or tax agencies with net income. Those
entities only accept cash. In
Chapter 2 we also explained why cash flow and accounting
profit (net income or profit
after tax) differ. As a quick reminder, it has to do with how
revenue is recognized, how
costs are matched to sales, and how some costs are allocated
over time via depreciation.
In this chapter we expand the discussion of cash flow to exactly
which type of cash flows
we use when analyzing investment opportunities or determining
a company’s financial
health. We draw on accounting, tax rules, and economic theory
to arrive at the appropri-
ate cash flows for financial analysis. In a corporate setting,
investment analysis is called
capital budgeting: the decision about how to best budget
investment capital to create
wealth for shareholders.
6.1 How to Compute Cash Flows
We discussed how to use accounting statements to estimate cash
flows in Chapter 2. There we showed a simple approach that
gave a reasonable approximation in most cases and a more

complete approach. The simple approach just added
depreciation expense back to net income to find an estimate of
cash flow. This approach is
usually fairly close to the exact value because depreciation is
usually the primary account
that causes net income and cash flow to differ.
The more complete approach begins with net income and
subtracts increases in assets and
adds increases in liabilities. Note that depreciation expense will
be included in changes in
fixed assets or property, plant, and equipment (PP&E), so is not
treated separately as it was
in the simple approach. If you are not comfortable with
translating accounting data into
cash flows, be sure to review the more detailed description of
the process in Chapter 2.
The appropriate cash flows for evaluating a corporate
investment decision are incremen-
tal after-tax cash flows. We will explain this definition in some
detail as the chapter pro-
gresses. For now, let’s look at the logic underlying each portion
of this expression.
Incremental: This is similar to the concept of marginal in
microeconomics. Economists
make decisions by comparing marginal costs and marginal
revenues. Recall that a prod-
uct’s marginal cost is the cost of making one more unit of the
product. If the marginal cost
is less than the marginal revenue (the price the unit will be sold
for), then the company
produces and sells that additional unit of production. Production
continues as long as
marginal cost is below marginal revenue. In finance we have

adopted the concept under-
lying marginal analysis to evaluate corporate investment
proposals. We compare the
additional cash flow that the proposed project or product will
generate to the additional
costs that the investment requires.
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After-tax: When we evaluate a project proposal, we do so from
the perspective of the
owners of the company. If the company is publicly traded, this
means we evaluate from
the shareholders’ perspective. Owners receive their return from
after-tax dollars. That is,
shareholders have a claim on after-tax profits. These are often
referred to as residual cash
flows because they are left after all other obligations have been
paid. We will see that taxes
can have a large effect on cash flows, so they cannot be
ignored.
Cash flows: As we discussed at the very beginning of this
chapter (and in Chapter 2), it is
cash that allows a company to pay its obligations—wages to
employees, bills from suppli-
ers, taxes, etc.—and remain financially viable.
Incremental Cash Flows
The use of incremental cash flows builds on the concept of
marginal costs and revenues in

economics. In corporate finance we don’t deal with individual
units of production, but
rather with investments in assets and other expenditures
(training, marketing, R&D, etc.)
to make new products or services, to expand production of
existing product lines, or to
reduce costs. In these situations we are dealing with a set of
expenditures, sometimes total-
ing millions or even billions of dollars. The underlying concept
is the same as in economics:
If additional revenues exceed additional costs, then the
investment should be pursued.
To make revenues and outlays (cash inflows and outflows)
comparable, we apply the pres-
ent value tools from Chapter 4 to translate all cash flows into
today’s dollars. If the present
value of cash inflows exceeds the present value of costs, then
the investment is said to have
a positive net present value, and so it is wealth-creating and
should be accepted. You will
learn more about actually computing a net present value in
Chapter 7. In this chapter we
focus on the most important input in the net present value
computation: cash flows.
The With-and-Without Principle
To determine incremental cash flows, we imagine the company
with and without the
proposed investment. The cash flows that the company
generates without the proposed
investment act as a baseline against which to identify changes
in cash flows. We subtract
the cash flows without the project from the company’s cash
flows if the project is accepted.

This difference is the incremental cash flow from the proposed
project.
You might ask how the with-and-without approach differs from
just measuring the pro-
posed product’s revenue and costs. If you add up all the costs of
designing, producing,
marketing, and distributing a new product, there is a good
chance that some of the costs
will not be incremental. Examples include sunk costs, allocation
of overhead, and canni-
balism of sales.
Sunk Costs
Consider research and development costs for a product. Before a
proposal can be submit-
ted for funding, money has to be spent designing the product. It
might seem like these
costs should be included in the proposal. But including them is
incorrect. They are sunk
costs. It doesn’t matter whether or not the new product is
pursued; these funds have been
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spent and cannot be recovered. In respect to these R&D
expenditures, the company is no
different with or without the project; in either case the money
has been spent. Another
common type of sunk cost is marketing research.
Basically, anything that is spent prior to the proposal being

submitted and analyzed can-
not be recovered, so it is a sunk cost.
Allocation of Overhead
Managerial accounting classes typically dedicate several weeks
to the allocation of over-
head costs. There are several approaches for doing this. If you
thought that cost account-
ing was challenging, we have good news for you: In finance we
do not allocate overhead.
If a cost is truly overhead and fixed, then the with-and-without
principle will not identify
it as incremental. Whether or not the proposed project is
accepted, the company will incur
the cost.
Let’s look at some examples. Sometimes factory floor space is
allocated by square feet
or square meters utilized by a project. Almost always, the rent
or lease expense for this
area has to be paid whether or not the new project is accepted.
Applying the with-and-
without concept means that if rent or lease payments do not
change, no floor space cost is
incremental to the project. We discuss a possible exception to
this rule under opportunity
costs below.
Salaried managers may have some portion of their time
allocated to a new project, but
unless there are new cash outlays associated with hiring a
replacement to complete other
assigned tasks the managers no longer have time to complete,
there is no allocation of
salaries to the new project. Only if salary expenses with the
project were greater than

without it would there be any incremental cost.
To summarize, we only look at changes in cash flows, so
anything that is truly fixed, and
by definition doesn’t change, is not incremental and therefore is
not a relevant cash flow
for corporate investment analysis purposes.
Cannibalism of Sales
Often new products are related to a company’s existing
products. This makes sense
because companies develop expertise in certain markets, certain
types of production,
certain types of distribution, and so on. This is an application of
the core competency
idea that is a central thesis of management. Examples abound.
Boeing makes passenger
jets; Campbell makes soup; McDonald’s sells fast food via
franchises; John Deere makes
farm equipment.
When a company introduces a new product, it is likely related
to existing product lines.
Thus, it may compete with existing products. Consider the
Campbell Soup Company and
its chicken soup line. Is Campbell’s Chicken & Stars very
different from Chicken Alphabet
soup or Chicken Noodle soup or Chicken NoodleO’s or Chicken
with Mini Noodles or
Homestyle Chicken Noodle soup or Chunky Classic Chicken
Noodle soup? When a new
chicken noodle soup variant is introduced, it is very likely that
some of its sales will come
from the existing chicken noodle variants that Campbell is
already selling. If so, how
should the revenues (and thus the cash inflows) from the new

product be calculated?
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Using the with-and-without principle we would compare the
revenues after the new soup
is introduced to the sales before and use this difference. The
difference is the incremental
revenue from the new product.
Computing incremental revenues can be complicated. Let’s go
back about 20 years to
the time when doctors began warning about people having too
much sodium (or salt)
in their diets. It was thought that too much salt could result in
higher blood pressure
and possibly other health prob-
lems. At that time people start-
ing shifting their purchases
toward low-sodium versions of
products. If the Campbell Soup
Company introduced a low-
sodium chicken noodle soup in
response to a competitor doing
so (although Campbell Soup
is so huge that it may not have
any significant competitors),
we would compute incremental
cash inflows differently.
The without baseline would be

Campbell Soup’s sales with-
out the low-sodium variety.
The sales would presumably be
lower because health-conscious
consumers would shift to the
competitor’s low-sodium soup.
If Campbell Soup introduces a low-sodium variety and prevents
sales from being lost,
those recovered sales should be included as incremental revenue
in the cash flows for
the low-sodium-soup analysis. This is a subtle distinction:
When a company introduces a
defensive product, it needs to consider the revenues protected
(i.e., not lost to competitors)
in addition to new revenues when determining incremental cash
inflows or benefits associ-
ated with the product.
After-Tax Cash Flows
Because we take the perspective of owners when analyzing
corporate investment propos-
als, and because owners are paid from after-tax dollars, we need
to consider taxes when
determining the appropriate cash flows for investment analysis.
Taxes affect investment cash flows in several ways. Companies
pay tax on their income.
Income is computed as revenues for the period minus tax-
deductible expenses for that
period. An important expense when evaluating an investment
proposal is depreciation
expense. Most large investments involve the purchase of long-
lived equipment, which
will have its cost depreciated over time via depreciation

expense.
Try Demonstration Problem 6.1 to assess your skill at
estimating cash flows.
Bloomberg/Getty Images
The Campbell Soup Company produces a variety of chicken
soups.
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Demonstration Problem 6.1: Cash Flow Estimation
You and several other entrepreneurial recent college graduates
are considering organizing a series
of bluegrass music festivals. You have found a group of bands
and musicians who will commit to
come and perform over a 3-day period each July for the next 5
years. You have found an old outdoor
amphitheater, but it requires some remodeling and new
equipment before it can be used. Before you
commit to this series of five bluegrass festivals, use the
following information to estimate the cash
flow from the festivals.
a. The musicians, as a group, want a guarantee of $25,000 per
year plus $1 per ticket sold. In
addition, the musicians need housing. The total housing expense
will be $4,500.
b. Refurbishing and equipping the pavilion will generate a

depreciation expense of $6,500 per
year for 5 years.
c. Insurance, security, equipment rental, lighting, and audio
services will total about $8,500 per
year. Printing, advertising, telephone use, postage, and other
expenses related to the festival
are estimated to total $7,500 per year.
d. With effective advertising, a member of the group, who is a
marketing professional, believes
the festival will draw people from throughout the region.
Tentatively, an average ticket price
of $10 is being considered.
e. Based on similar events elsewhere, she estimates total ticket
sales over the 3 days will be
about 6,500 the first year, growing to 8,000 in years 2 and 3,
and to 9,000 in years 4 and 5.
f. The appropriate tax rate for this project is 28%.
Solution
Revenues
Year 1 2 3 4 5

Tickets 6,500 8,000 8,000 9,000 9,000
Revenue at $10/ticket $65,000 $80,000 $80,000 $90,000
$90,000
Expenses
Year 1 2 3 4 5
Musicians’ fee $25,000 $25,000 $25,000 $25,000 $25,000
Musicians’ gate receipts 6,000 8,000 8,000 9,000 9,000
Musicians’ housing 4,500 4,500 4,500 4,500 4,500
Depreciation 6,500 6,500 6,500 6,500 6,500
Insurance, etc. 20,500 20,500 20,500 20,500 20,500
Total expenses $62,500 $64,500 $64,500 $65,500 $65,500
Taxes, Profits, and Cash Flow
Year 1 2 3 4 5

Profit $2,000 $15,500 $15,500 $24,500 $24,500
Tax 560 4,340 4,340 6,860 6,860
Net profit 1,440 11,160 11,160 17,640 17,640
Cash flow 7,940 17,660 17,660 24,140 24,140
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The Depreciation Tax Shield
The income statement in Table 6.1 includes a line for
depreciation expense. This expense
reduces taxable income, so reduces the amount of taxes paid. In
Table 6.2 depreciation
expense is removed, so taxable income and taxes go up.
Table 6.1: Income statement with depreciation expense
Income Statement for the Year 2012

Revenue 1,000,000
COGS 487,500
Gross margin 512,500
Depreciation expense 200,000
Taxable income 312,500
Taxes (32%) 100,000
Net income 212,500
Add back depreciation 200,000
Cash flow 412,500
Table 6.2: Income statement without depreciation expense
Income Statement for the Year 2012
Revenue 1,000,000
COGS 487,500

Gross margin 512,500
Depreciation expense 0
Taxable income 512,500
Taxes 164,000
Net income 348,500
Add back depreciation 0
Cash flow 348,500
In Table 6.1 depreciation expense reduced taxable income by
$200,000. Because of this
tax shield, taxes decreased by $64,000, from $164,000 (in Table
6.1 without depreciation
expense) to $100,000 in Table 6.2. The tax shield effect can be
estimated directly from
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(6.1) Tax Savings 5 Depreciation Expense 3 Tax Rate
Substituting in the values we are given gives us
Tax Savings 5 $200,000 3 0.32
5 $64,000
In Tables 6.1 and 6.2 notice how the presence of depreciation
expense affects cash
flow. Cash flow in Table 6.1, estimated by adding depreciation
expense to net income,
is $412,500. When depreciation expense is removed, as shown
in Table 6.2, cash flow
decreases to $348,500. This $64,000 fall in cash flow arises
because of the loss of the depre-
ciation tax shield. The change in cash flow is exactly equal to
the tax savings estimated
with Equation (6.1).
While there are tax savings and cash flow increases in years
when depreciation expense is
recognized, you need to think about the cash flow implications

over an asset’s entire life.
When the asset is purchased, a large outlay is made. Think of
this as a negative cash flow
or an outflow of cash. Over the depreciable life of the asset, the
tax savings from depre-
ciation expense generate positive cash flows. Figure 6.1 shows
the timeline of cash flows
associated with the purchase and depreciation of a long-lived
asset.
Figure 6.1: Timeline of cash flows associated with a long-lived
asset
In Figure 6.1 a company purchases a machine (or some other
asset) for $1,200,000. The
company recognizes $200,000 of depreciation expense each year
for the wear and tear
(or the consumption) of the machine for the next 6 years.
Assuming a tax rate of 32%, the
$200,000 of depreciation expense reduces taxable income by
$200,000 and thereby reduces
taxes by $64,000. It is the $64,000 annual tax savings that we
recognize as a cash flow.
While these tax savings are great, you need to remember that
they exist only because the

company spent $1,200,000 on the machine initially. The tax
shields are not free.
Depreciation Tax Shields
of $64,000 per year based on
32% tax rate
2
Time (years)
1 43 65
0
–$1,200,000
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Ignoring the time value of money for a moment, we see that the
sum of the tax shield cash

flows is $384,000 (5 6 3 $64,000), not $1,200,000. The sum of
the tax shields is less than
the amount spent because, though over the 6-year asset life
taxable income is reduced
by $1,200,000 ($200,000 per year), this only reduces taxes, and
creates cash flows, by
$64,000 per year. Notice that
$1,200,000 3 0.32 5 $384,000. If
the time value of money is con-
sidered, then the present value
of the depreciation tax shields is
less than $384,000. Sometimes
government economic stimu-
lus policies accelerate deprecia-
tion, even allowing companies
to take all of the depreciation in
the first year. This increases the
value of the tax shields in terms
of their present value.
Tax Deductible Expenses
For companies, almost all busi-
ness expenses are tax deduct-
ible; that is, they are subtracted
from revenue and reduce tax-

able income. We can calculate
after-tax cost using
(6.2) After-Tax Cost 5 Cost 3 (1 2 Tax Rate)
The after-tax cost of a deductible expense for a $2,000 outlay
and a 35% tax rate is then
given by
After-Tax Cost 5 $2,000 3 (1 2 0.35)
5 $1,300
The company writes a check to the supplier for $2,000, but after
the cost reduces taxable
income, the company realizes a tax savings of $700, making the
after-tax cost of the $2,000
just $1,300.
For both depreciation and deductible expenses, the tax savings
are greater the higher the
tax rate. This also means that the savings decrease with a drop
in the tax rate. A company
with losses, which would pay no taxes, would see little
immediate benefit from either
depreciation or tax-deductibility of expenses. If the losses are

temporary, the company
might receive value via tax-loss carry forwards (which enable
firms to deduct the losses
from 1 year from future profits in order to lower taxes in future
years) or other provisions
of the tax code.
Pat Byrnes/The New Yorker Collection/www.cartoonbank.com
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www.cartoonbank.com
This approach [(dollars 3 (1 2 Tax Rate)] can also be applied to
cash inflows, so
(6.3) After-Tax Earnings 5 Earnings 3 (1 2 Tax Rate)
For example, if you earn an extra $5,000 and your tax rate is
22%, then your after-tax earn-
ings will be $3,900 as

After-Tax Earnings 5 Earnings 3 (1 2 Tax Rate)
5 $5,000 3 (1 2 0.22)
5 $3,900
Your 22% tax rate means you pay $1,100 on $5,000 of
additional earning, leaving $3,900
after-tax income.
Recapture of Depreciation, Gains, and Losses
As companies upgrade equipment and change their product mix
(and thereby the
machines required for production), they sell some assets. If an
asset is sold for its current
book value (usually, original cost less accumulated
depreciation), then there are no tax
consequences. However, if the sales price differs from the
current book value, then we
need to consider taxes.
If the sales price falls between the original cost and the current
book value, then the
company depreciated the asset too quickly. This extra
depreciation is recaptured by the
tax authorities in the form of tax at the company’s ordinary tax

rate. Since the company
reduced its taxes too much, it has to return some of those
savings. Here is an example: A
construction company bought a bulldozer 3 years ago for
$150,000. It depreciated the bull-
dozer using the straight-line method at $30,000 per year,
assuming a 5-year life. The cur-
rent book value is $60,000 ($150,000 2 3 3 $30,000). It decides
to replace the machine, so it
sells it for $75,000. The sales price of the used machine
($75,000) exceeds the current book
value ($60,000). The company depreciated the bulldozer
$15,000 too much, so it must pay
taxes on that excessive depreciation. Assuming the tax rate is
35%, the company would
have a tax bill of $5,250 (5 0.35 3 $15,000). The after-tax
income from the sale of the used
bulldozer would be $75,000 2 $5,250 5 $69,750.
There isn’t anything wrong (i.e., it isn’t illegal) for the sales
price of an asset to differ from
the asset’s book value. Market values fluctuate, and
depreciation is just a guess about the
loss of economic value of a machine or factory. When the sales
price is finally known, then

there is a settling up.
If the sales price is less than the current book value, then the
company has a loss (or didn’t
depreciate fast enough) and receives tax relief equal to the tax
shield if it had depreciated
the asset to the sales price. Using the bulldozer example above,
suppose the sales price of
the used machine was $40,000. The current book value is
$60,000, as above. Therefore the
company deserves $20,000 of extra depreciation, which would
reduce its taxes by $7,000
(5 0.35 3 $20,000). The after-tax income from the sale of the
used bulldozer would be
$40,000 (from the sale) 1 $7,000 (from tax savings) 5 $47,000.
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The last possibility is that the asset is sold for more than its
original price. This situation is
probably rare for equipment, but it is actually common in real

estate transactions and for
other assets that typically appreciate in value, such as antique
cars.
Suppose that in 1957 a company bought its CEO a Ford
Thunderbird to use as a com-
pany car. The price of the car in 1957 was $3,408. Over the
years repairs added about
$3,000 to this cost, resulting in a total investment of $6,408.
This is called the cost basis. For
information about these tax issues, see the IRS item in the Web
Resources section at the
end of the chapter. Today, according to several websites, the car
would sell for between
$30,000 and $60,000. Suppose the company had depreciated the
car to zero over 6 years
many years ago (presumably by 1963 or 1964) but today sold it
for $40,000. It would
have to recapture $6,408 of depreciation. The gain beyond
$6,408 would be a long-term
capital gain taxed at the preferential 15% long-term gain rate.
The first $6,408 would be
taxed at the company’s ordinary rate of 35%. The remaining
amount, the capital gain of
$40,000 2 $6,408 5 $33,592, would be taxed at 15%. The after-

tax cash flow from selling
this classic roadster would be
After-Tax Cash Flow 5 $40,000 2 $6,408 3 0.35 2 $33,592 3
0.15
5 $40,000 2 $2,242.80 2 $5,038.80
5 $32,718.40
As an interesting aside, consider the following: In 1957 Ford
hand-built 12 supercharged
racing Thunderbirds. One came to auction in 2009 with an
estimated price of $300,000 to
$350,000! Ford also made 222 factory-built supercharged
Thunderbirds in 1957. They sell
for well over $100,000 today.
Figure 6.2 summarizes the tax issues of selling a piece of
equipment. If the sales price is
below the current book value (in the yellow area), then there is
a loss. If the sales price is
in the green area, then depreciation needs to be recaptured. If
the sales price is higher than
the original cost (or current cost basis), then there will be
recapture of depreciation and a
capital gain.

Figure 6.2: Losses, recapture, and gains from the sale of an
asset
We have presented a somewhat simplified version of these tax
issues. There are some
potential complications when selling more than one asset in a
fiscal year, and when selling
to a related party. If this topic interests you, be sure to look at
the IRS tax document in the
Web Resources at the end of the chapter.
Current Book
Value
Original Cost
(or Cost Basis)
Sales Price
Loss Recapture Depreciation Capital Gain
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CHAPTER 6Section 6.2 Categories of Cash Flows
6.2 Categories of Cash Flows
When we analyze proposed investments, it is handy to
categorize cash flows into three types. By creating a checklist
for each type, we can help to assure that nothing has been left
out of the analysis. The three categories of cash flows are
• initial investment,
• operating cash flows, and
• terminal cash flows.
Initial Investment
For the purposes of analysis we assume that the initial
investment occurs today, at time
t 5 0. This ensures that the expenditures associated with the
initial investment are in
today’s dollars or are present values that need no further
discounting. All other cash flows
will be discounted using present value techniques to time t 5 0,
so that cash flows can be
compared.

The initial investment always includes the purchase of new
equipment or facilities or
some other large outlay. Remember that we estimate these cash
flows so that they can be
used in an analysis of whether or not an investment should be
made. If there is no signifi-
cant outlay for equipment or facilities, then there is no
investment to examine.
If the proposed investment is to replace existing equipment,
then the initial investment
will usually include proceeds from the sale of the old
equipment, with appropriate tax
adjustments.
Any additional (uncompleted and not contracted by time t 5 0)
R&D or marketing
research would also be included, as would training for
employees and specific installation
costs for equipment or machinery. Costs for R&D and/or
marketing research that have
already been paid are not included, as they are sunk costs.
Part of the initial investment that is often overlooked is working
capital. To produce and

sell merchandise, a company needs raw materials from suppliers
(which generate accounts
payable), to maintain inventory (which adds to the inventory
account), and often it must
offer credit to customers (which creates accounts receivable).
Using the with-and-without
concept, changes in these working capital accounts become part
of the incremental cash
flows for the project. At the start of the project the investment
will include some level of
inventory and accounts receivable less the amount of
spontaneous financing provided by
suppliers through accounts payable. As the sales of the product
increase, additional work-
ing capital investment may be required to support higher sales
levels.
Operating Cash Flows: New Revenue or Profit
The goal of a new product introduction or other corporate
investment is to increase share-
holder wealth. In the introduction to this chapter we said that
this means increasing cash
flows available for owners or residual cash flows. As discussed
in Chapter 2 and above,

cash flows are approximated by net income plus depreciation
expense, or more exactly as
net income plus changes in assets and liabilities.
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We will show two different ways to get the approximate cash
flows, and then later con-
sider changes in working capital (the main source of changes in
assets and liabilities for
most projects). The two approaches differ by the information
with which they begin: EBT
(earnings before taxes) or EBDT (earnings before depreciation
and taxes).
Approach 1: The EBT Approach
If you know the change in earnings before taxes (taxable
income), then you can find the
after-tax operating cash flows by creating the very bottom of an
income statement and
adding depreciation expense to net income. This approach is

also excellent if you are
creating pro forma or projected income statements for the
proposed project. An example
shows this slightly extended version. See A Closer Look: Is
EBITDA a Measure of Cash Flow?
for an in-depth discussion of using earnings before interest,
taxes, depreciation, and amor-
tization (EBITDA) as a measure of cash flows.
A Closer Look: Is EBITDA a Measure of Cash Flow?
Some financial analysts specialize in evaluating whether firms
can borrow more money. In the 1980s
these debt analysts began using EBITDA as an indicator of a
company’s ability to repay its debt.
EBITDA quickly became the favorite tool of debt analysts,
particularly those studying high-yield or
junk bonds. We know from our discussion of transforming
accounting profits into cash flow that one
method is to add depreciation (and amortization) to net income.
EBITDA does this. It also adds back
taxes and interest payments. Because interest is paid before
taxes, EBITDA is a reasonable estimate
of the cash available to make those interest payments. If
EBITDA is sufficiently high (approximately

two or three times the total debt service payments), analysts feel
comfortable recommending that
the company borrow more money.
Over time, other analysts started using EBITDA as an estimate
of cash flow. Equity analysts estimate
the value, today and in the near future, of shares of stock.
Depending on their valuation, the ana-
lysts issue recommendations to buy, hold, or sell the stock.
Many stock price valuation models use
estimates of future cash flows available to stockholders to form
a current share price. Some equity
analysts and companies themselves began using EBITDA to
argue for higher share prices. By defini-
tion, the EBITDA must be larger than cash flow estimates that
add depreciation to net income, so that
the valuation can support a higher stock value. Soon investment
analysts began criticizing the use of
EBITDA as a universally appropriate measure of cash flow.
Their argument, in a nutshell, was that the
measure of cash flow appropriate for one use might not be
appropriate for other uses. While EBITDA
may be an appropriate measure for lenders, it is not appropriate
for stockholders. Stockholders care
about the cash paid for interest and taxes. Equity investors are

interested in after-tax cash flows. In
fact, equity investors are interested in cash flows after all
payments have been made. These residual
(or remaining) cash flows are available to investors, so they are
the best measure of an investment’s
value to stockholders. As this brief discussion makes clear,
there is not a single measure of cash flow
that is always appropriate. The measure of cash flow needs to
fit the job it is being applied to.
byr80656_06_c06_141-160.indd 153 3/28/13 3:32 PM
As an example, consider that a new product will generate sales
of $20,000 per year. COGS
(direct costs) will be $14,000 and there will be $1,500 of
depreciation expense. The com-
pany’s tax rate is 30%. Find the annual after-tax cash flows for
this product.
First, subtracting COGS from sales gives us the gross margin:

Sales $20,000
COGS 2$14,000
Gross margin $6,000
Then subtract depreciation to get the taxable income:
Gross margin $6,000
Depreciation expense 2$1,500
Taxable income $4,500
A tax rate of 30% means $1,350 must be paid in taxes, so that
the net income will be
Taxable income $4,500
Tax (30%) 2$1,350
Net income $3,150
Adding back depreciation gives the after-tax cash flow:

Net income $3,150
Add back depreciation 1$1,500
After-tax cash flow $4,650
Demonstration Problem 6.2: Cash Flow Estimation
Lincoln Composite Materials produces aerospace parts from
fiberglass, Kevlar™, and other plastics.
Last year Lincoln had a net income of $2,746,347 on sales of
$68 million. The depreciation expense
was $710,558 and taxes were $976,994. Use this information to
provide a rough estimate of Lincoln’s
cash flow.

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