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

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…