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Discount Cash Flows, Not Profits

Up to this point we have been concerned mainly with the mechanics of discounting and with the various methods of project appraisal. We have had almost nothing to say about the problem of what you should discount. The first and most important point is this: to calculate net present value you need to discount cash flows, not accounting profits. We stressed the difference between cash flows and profits earlier. Here we stress it

again. Income statements are intended to show how well the firm has performed. They do not track cash flows.

If the firm lays out a large amount of money on a big capital project, you would not conclude that the firm performed poorly that year, even though a lot of cash is going out the door. Therefore, the accountant does not deduct capital expenditure when calculating the year s income but instead depreciates it over several years.

That is fine for computing year-by-year profits, but it could get you into trouble when working out net present value. For example, suppose that you are analyzing an investment proposal. It costs $2,000 and is expected to bring in a cash flow of $1,500 in the first year and $500 in the second. You think that the opportunity cost of capital is 10 percent and so calculate the present value of the cash flows as follows:

The project is worth less than it costs; it has a negative NPV:

NPV = $1,776.86 $2,000 = $223.14

The project costs $2,000 today, but accountants would not treat that outlay as an immediate expense. They would depreciate that $2,000 over 2 years and deduct the depreciation from the cash flow to obtain accounting income:

Thus an accountant would forecast income of $500 in Year 1 and an accounting loss of $500 in Year 2. Suppose you were given this forecast income and loss and naively discounted them.

Now NPV looks positive:

Of course we know that this is nonsense. The project is obviously a loser; we are spending money today ($2,000 cash outflow) and we are simply getting our money back ($1,500 in Year 1 and $500 in Year 2). We are earning a zero return when we could get a 10 percent return by investing our money in the capital market. The message of the example is this:

When calculating NPV, recognize investment expenditures when they occur, not later when they show up as depreciation. Projects are financially attractive because of the cash they generate, either for distribution to shareholders or for reinvestment in the firm. Therefore, the focus of capital budgeting must be on cash flow, not profits.

Here is another example of the distinction between cash flow and accounting profits. Accountants try to show profit as it is earned, rather than when the company and the customer get around to paying their bills. For example, an income statement will recognize revenue when the sale is made, even if the bill is not paid for months. This practice also results in a difference between accounting profits and cash flow. The sale generates immediate profits, but the cash flow comes later.

Sales before Cash

Reggie Hotspur, ace computer salesman, closed a $500,000 sale on December 15, just in time to count it toward his annual bonus. How did he do it? Well, for one thing he gave the customer 180 days to pay. The income statement will recognize Hotspur s sale in December, even though cash will not arrive until June. But a financial analyst tracking cash flows would concentrate on the latter event.

The accountant takes care of the timing difference by adding $500,000 to accounts receivable in December, then reducing accounts receivable when the money arrives in June. (The total of accounts receivable is just the sum of all cash due from customers.) You can think of the increase in accounts receivable as an investment it s effectively a 180-day loan to the customer and therefore a cash outflow. That investment is recovered when the customer pays. Thus financial analysts often find it convenient to calculate cash flow as follows:

Note that this procedure gives the correct cash flow of $500,000 in June.

It is not always easy to translate accounting data back into actual dollars. If you are in doubt about what is a cash flow, simply count the dollars coming in and take away the dollars going out.