JAMES P. WESTON: Hi.

Welcome back to finance for non-finance professionals.

This week we've been talking about measuring cash creation and cash

flow through the financial statements.

In this short lesson, we're going to walk through a calculation of free cash

flows and we're going to take that through to what

we would do with it by circling back to the lessons

that we did in week one and two.

So our measure of free cash flow operating profit after tax,

less any increase in working capital, plus depreciation,

subtracting off any capital expenditures,

and adding back any after tax salvage value.

What we're going to do with that measure of free cash flow

is go back to week two and construct a net present value, internal rate

of return, payback period.

All the capital budgeting tools that we learned in week two,

we're going to now use the free cash flow

analysis to go back and circle back to our measures of capital budgeting.

So let's go to a spreadsheet, and let's work through the example

that we did in the previous lesson, and calculate some of our capital budgeting

tools.

OK.

So here's a really simple spreadsheet that

contains the example that we did in the previous lesson

about constructing free cash flows.

So let's go back and first off reconstruct free cash flows.

In period zero, we had nothing going on in the income statement,

because we haven't had a full year for the flow yet.

But we did have a spending of $500.

So I'm going to put that in as a subtraction.

I subtract $500 CAPEX.

And then I'm going to subtract the increase of $150,

because really I'm going from $0 to $150 in order to start the project.

It's like I'm investing $150 of working capital.

So my total spending is $650.

So $650 in spending.

Now let's go back in the following years and construct

free cash flow in each period.

And that's going to be my net operating profit after tax.

I'm going to subtract any increase in working capital.

So that's going to be from $100 minus the previous working capital of $150.

And then I'm going to add back depreciation,

because that money never really left.

I'm going to subtract any capital expenditures from capital spending.

There's nothing there, but I'll subtract it anyway for completeness.

And then I'm going to add back any asset sales or terminal values.

Again, there won't be anything until the end,

but I'll add it in and each formula for completeness.

OK.

So there's my free cash flow calculation.

And that comes out to $220.

And then I'm just going to Control C, copy,

and then paste that in each period.

So that generates $220 in free cash flow in period one,

$220 in free cash flow in period two, and $420

in free cash flow in period three.

The extra $200 in period three comes from the fact

that I'm sweeping clean the balance sheet by getting rid of the assets

that I had left on the balance sheet.

I had a net property plant and equipment of $200.

I'm getting rid of it by selling it.

That's generating the extra $200 in free cash flow.

OK.

So now we can go through and calculate the net present value.

How are we going to do that?

Well the one thing that we can do is just follow the formula.

And that's minus the initial investment-- it's already a minus.

So 650.

Then I'm going to say plus what-- $220, my period one cash flow.

And what am I going to do?

I'm going to discount it by my discount rate up here-- 10%,

and then add on my second period cash flow and discount that by 1 plus 10%

raised to two, two periods out, and then add on my third period free cash flow,

and discount that.

1 plus 10% raise to three per.

And there's my net present value formula in Excel.

When I hit Return, $47.37.

So positive NPV.

That capital budgeting tool says do the project.

There's an easier way to do this in Excel, which is using the NPV formula.

If I just say equals NPV-- and most spreadsheet programs

have this formula built into them.

It knows what to do.

It says what rate are you using?

I go and get 10%.

And then it says what are your values.

I go and I grab and I highlight all my future cash flows.

All I need to do now is tag on my initial cash flow

and NPV does the rest of the work for me.

Oops, that's in percent.

Let's format that right.

There.

And I get the same answer using the formula.

That's a nice easier way to do it.

IRR-- what's my internal rate of return on the project?

Well, that's easy in Excel or any spreadsheet program.

I can just say equals IRR, and go and get my cash flows.

And the spreadsheet, like we talked about, is going to solve that for me.

Whoops.

Let's put that in percentage terms.