There are three main types of standard cash flows:
- Operating cash flows: These are the cash flows generated by a company's core business activities. They include revenues from sales, minus expenses such as cost of goods sold, operating expenses, and taxes.
- Investing cash flows: These are the cash flows associated with a company's investments in long-term assets, such as property, plant, and equipment. They include cash outflows for capital expenditures, minus cash inflows from the sale of long-term assets.
- Financing cash flows: These are the cash flows associated with a company's financing activities, such as raising capital through debt or equity issuance. They include cash inflows from debt or equity issuance, minus cash outflows for debt repayment or dividend payments.
The economic equivalence formulae for these different types of cash flows are as follows:
- Operating cash flows: Present value = (Annual operating cash flow * Number of years) / Discount rate
- Investing cash flows: Present value = (Cash outflow for capital expenditure * Present value factor) - (Cash inflow from sale of long-term asset * Present value factor)
- Financing cash flows: Present value = (Cash inflow from debt or equity issuance * Present value factor) - (Cash outflow for debt repayment or dividend payments * Present value factor)
The discount rate is the rate of return that investors expect to earn on their investments. The present value factor is a function of the discount rate and the number of years in the future.
By using these formulae, investors can compare the economic value of different types of cash flows. This information can be used to make investment decisions, such as whether to buy or sell a stock or bond.
Here are some examples of how standard cash flows can be used:
- A company is considering investing in a new project that will generate $100,000 in annual operating cash flows for the next 10 years. The company's discount rate is 10%. The present value of these cash flows is $614,100. This means that the project is worth investing in, because the present value of the future cash flows is greater than the initial investment.
- A company is considering issuing new debt to finance a new project. The company expects to raise $100 million in new debt. The interest rate on the debt is 5%. The present value of the debt payments is $95.24 million. This means that the company will be able to afford to make the debt payments, even if the project does not generate as much cash flow as expected.
- A company is considering buying back its own stock. The company has $100 million in cash that it could use to buy back its stock. The company's stock is currently trading at $50 per share. If the company buys back its stock, it will reduce the number of shares outstanding and increase its earnings per share. This could lead to an increase in the stock price.
Standard cash flows are an important tool for investors and companies. By understanding how to calculate and use standard cash flows, investors can make better investment decisions and companies can make better financial decisions.