Aswath Damodaran – Session 12 (MBA): Earnings to Cash flows to Incremental Cash Flows

 

Published on Mar 21, 2016

In this session, we started by stating our ideal measure of return: it should be based upon cash flows, focus on just the incremental and be time weighted. After defining project broadly as including any type of investment, small or large, revenue generating or cost cutting, we started on the Rio Disney theme park analysis. We laid out the initial costs for the theme park and the assumptions about expenses, both direct and allocated. We began the class today by extending the return on capital concept to entire companies and argued that notwithstanding its accounting limitations, comparing the return on capital to the cost of capital provides us with a basis for measuring whether a company’s existing investments are good (or not). We then returned to the Rio Disney analysis and moved from earnings to cash flows, by making three standard adjustments: add back depreciation & amortization (which leaves the tax benefit of the depreciation in the cash flows), subtract out cap ex and subtract out changes in working capital. Finally, we introduced the key test for incremental cash flows by asking two questions: (1) What will happen if you take the project and (2) What will happen if you do not? If the answer is the same to both questions, the item is not incremental. That is why “sunk” costs, i.e., money already spent, should not affect investment decision making. It is also the reason that we add back the portion of allocated G&A that is fixed and thus has nothing to do with this project. I have attached the post class test for today, with the solution.
Slides: http://www.stern.nyu.edu/~adamodar/po…
Post class test: http://www.stern.nyu.edu/~adamodar/pd…
Post class test solution: http://www.stern.nyu.edu/~adamodar/pd…

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