Measuring Cash Flows

• Free cash flow to equity = Net income - (Capital expenditures - Depreciation) - Change in noncash working capital + (New debt raised - Debt repayment)

• Free cash flow to firm = Operating income (1 - Tax rate) - (Capital expenditures - Depreciation) - Change in noncash working capital

The expenses incurred by a firm can be categorized into three groups:

• Operating expenses - like labor and material, which are expected to generate benefits only in the current period
• Capital expenses - like land, building, and equipment, which are expected to generate benefits over multiple periods
• Financial expenses - such as interest expenses, which are associated with the use of nonequity financing

Misleading accounting measures of earnings:

1. The inclusion of capital expenses such as R&D in the operating expenses
2. Financial expenses such as operating leases expenses that are treated as operating expenses

Capitalized R&D Expenses:

• To capitalize and value research assets, we make an assumption about how long it takes for R&D to be converted, on average, into commercial products. This is called the amortizable life of these assets
• Once the amortizable life of R&D expenses has been estimated, the next step is to collect data on R&D expenses over past years ranging back to the amortizable life of the research asset

Value of the research asset =

=> Adjusted book value of equity = Book value of equity + Value of the research asset

=> Adjusted operating income = Operating income + R&D expenses - Amortization of research asset

=> Adjusted net income = Net income + R&D expenses - Amortization of research asset

Techniques for Managing Earnings

• Planning Ahead
• Revenue recognition
• Book revenues early
• Capitalize operating expenses
• Write-offs
• Use reserves
• Income from investments

Adjustments to Income

• One-time expenses or income that is truly one-time
• Expenses and income that do not occur every year but seem to recur at regular intervals
• Expenses and income that recur every year but with considerable volatility
• Items that recur every year that change signs - positive in some years and negative in others

Reinvestment Needs

• Two components go into estimating reinvestment:

1. Net capital expenditure
2. Investment in working capital

Net Capital Expenditure :-

• In estimating net capital expenditure, we generally deduct depreciation from capital expenditure
• The positive cash flows from depreciation pay for at least a portion of capital expenditures and it is only the excess that represents a drain on the firm's cash flow
• When estimating the capital expenditures to use for forecasting future cash flows, we should normalize capital expenditures

Method I: by averaging capital expenditures over a number of years

• Estimate the average capital expenditures over the last four or five years for a manufacturing firm and use that number rather than the capital expenditures from the most recent year
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