Essay About Free Cash Flow And Accounting Rate Of Return

Key Take Aways Financial Accounting
Key Takeaways – Session 7Please review formulas for PV.  “regular”, PV annuity and PV perpetuities.Also bear in mind FCF (free cash flow) calculation formula (we’ll delve deeper on this after break)EBIT*(1-t) + depreciation – CAPEX – investment in WC.Possible Criteria to be used to choose projectsARR (accounting rate of return or book yield)Mean net income/average investment.Drawbacks: 1) uses accounting numbers, not cash flows and 2) ignores time value of money.Payback PeriodAnswers the question: “how long does it take me to get my money back?”Has a bias for liquidity at the (potential) expense of profitability.Used in combination to NPV (profitability or value metric) to make decisions.Payback is particularly relevant when liquidity is tight.Net Present Value (NPV)Discount project’s FCFs using our (firm’s) cost of capital. If NPV negative, reject, as FCFs cannot service required rate of return by our investors.  If zero or positive, accept project.Internal Rate of Return (IRR)It is the discount rate that makes NPV=0We accept projects that have an IRR higher than our cost of capitalProblems with IRR:With particularly high IRRs, it is unreasonable to assume that we can reinvest those cash flows in other projects at the same rate.Does not tell us about the scale of the project (it may offer a phenomenal return… on a very small investment).Possibility of multiple IRRs.  The metric is useless then.Is misleading in mutually exclusive projects.  next session we shall see examples of why the last two problems may arise.Best,Carmen