Aswath Damodaran Session 13: From Earnings to Incremental Cash Flows – A Journey

Aswath Damodaran Session 13: From Earnings to Incremental Cash Flows – A Journey

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Published on Mar 9, 2016

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). If you are interested and want some light reading material for your flight to Jamaica (which is where I am sure you are going for Spring break), try this absolutely scintillating, cannot-be-put-down, amazing (not, not and definitely not) blog post that I put up at the start of this year on the topic:
http://aswathdamodaran.blogspot.com/2...
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.
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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About the Author

Aswath Damodaran
Please note that I do not read comments posted here, nor respond to messages here. I don't have the time. If you want my attention, you must seek it directly at my blog. Aswath Damodaran is the Kerschner Family Chair Professor of Finance at the Stern School of Business at New York University. He teaches the corporate finance and equity valuation courses in the MBA program. He received his MBA and Ph.D from the University of California at Los Angeles. His research interests lie in valuation, portfolio management and applied corporate finance. He has written three books on equity valuation (Damodaran on Valuation, Investment Valuation, The Dark Side of Valuation) and two on corporate finance (Corporate Finance: Theory and Practice, Applied Corporate Finance: A User’s Manual). He has co-edited a book on investment management with Peter Bernstein (Investment Management) and has a book on investment philosophies (Investment Philosophies). His newest book on portfolio management is titled Investment Fables and was released in 2004. His latest book is on the relationship between risk and value, and takes a big picture view of how businesses should deal with risk, and was published in 2007. He was a visiting lecturer at the University of California, Berkeley, from 1984 to 1986, where he received the Earl Cheit Outstanding Teaching Award in 1985. He has been at NYU since 1986, received the Stern School of Business Excellence in Teaching Award (awarded by the graduating class) in 1988, 1991, 1992, 1999, 2001, 2007, 2008 and 2009, and was the youngest winner of the University-wide Distinguished Teaching Award (in 1990). He was profiled in Business Week as one of the top twelve business school professors in the United States in 1994.