Introduction to Corporate Finance

PArT 1: INTrODuCTION

The financing flows result from debt and equity financing transactions. Taking on new debt (short-term or

long-term) results in a cash inflow; repaying existing debt requires a cash outflow. Similarly, the sale of

shares generates a cash inflow, whereas the repurchase of shares or payment of cash dividends results in

a cash outflow. In combination, the operating, investment and financing cash flows during a given period

affect the company’s cash and marketable securities balances.

Monitoring cash flow is important both for financial managers and for outside analysts trying to

estimate a company’s worth. Managers and analysts track a variety of cash flow measures. Among these,

one of the most important is free cash flow.

Free Cash Flow

The measure of free cash flow (FCF) is the amount of cash flow available to investors – the providers of debt

and equity capital. It represents the net amount of cash flow remaining after the company has met all

operating needs, including working capital commitments and capital expenditures. Free cash flow for a

given period can be calculated in two steps.

First, we find the company’s net operating profits after taxes (NOPAT), the company’s earnings before

interest and after taxes:^4

Eq. 2.1 NOPAT = EBIT × (1 – T)

Where

EBIT = earnings before interest and taxes

T = corporate tax rate

Adding depreciation back into NOPAT yields operating cash flow (OCF), which is the amount of cash

flow generated by the company’s operations.

Eq. 2.2 OCF = NOPAT + Depreciation

Note that because depreciation is a non-cash charge, we add it back when determining OCF.

Non-cash charges – such as depreciation, amortisation and depletion allowances – are expenses that

appear on the income statement but do not involve an actual outlay of cash. Almost all companies list

depreciation on their income statements, so we focus on depreciation in our presentation. But when

amortisation or depletion allowances occur in a company’s financial statements, they are treated in a

similar manner.

Substituting Equation 2.1 for NOPAT into Equation 2.2, we obtain a single equation for operating

cash flow:

Eq. 2.3 OCF = [EBIT × (1 – T)] + Depreciation

Substituting the values from GPC’s 2016 income statement (from Table 2.2), and assuming a 38.70%

tax rate (T = 38.70%), as implied by GPC’s 2016 income statement, we get GPC’s operating cash flow:

OCF = $1,671 × (1.00 – 0.3870) + $633 = $1,024 + $633 = $1,657

Hence, GPC’s OCF was $1,657 million.

4 A related indicator of a company’s financial performance is earnings before interest, taxes, depreciation and amortisation (EBITDA). Analysts

use EBITDA to compare profitability of companies, because it measures revenue minus all expenses other than interest, taxes, depreciation

and amortisation. It thereby eliminates the effects of financing and accounting decisions. Although EBITDA is a good measure of profitability,

it does not measure cash flows.

financing flows
Cash flows that result from
debt and equity financing
transactions

free cash flow (FCF)
The net amount of cash flow
remaining after the company
has met all operating needs,
including working capital
commitments and capital
expenditures. It represents the
cash amount that a company
could distribute to debt and
equity investors after meeting
all its other obligations

net operating profits after
taxes (NOPAT)
The amount of earnings before
interest and after taxes,
which equals EBIT × (1 – T),
where EBIT is earnings before
interest and taxes and T
equals the corporate tax rate

operating cash flow (OCF)
The amount of cash flow
generated by a company from
its operations. Mathematically,
it is the earnings before
interest and taxes (EBIT) minus
taxes plus depreciation

non-cash charges
Expenses, such as
depreciation, amortisation
and depletion allowances,
that appear on the income
statement but do not involve
an actual outlay of cash