The Importance of Cash Flows
The most important job of a financial manager is to create value from the firm’s capital budgeting, financing, and
net working capital activities. How do financial managers create value? The answer is that the firm should:
1. Try to buy assets that generate more cash than they cost.
2. Sell bonds, stocks, and other financial instruments that raise more cash than they cost.
Thus, the firm must create more cash flow than it uses. The cash flows paid to bondholders and stockholders of the
firm should be greater than the cash flows put into the firm by the bondholders and stockholders.
The interplay of the firm’s activities with the financial markets is illustrated in Figure 1.3. The arrows in Figure
1.3 trace cash flow from the firm to the financial markets and back again. Suppose we begin with the firm’s
financing activities. To raise money, the firm sells debt and equity shares to investors in the financial markets. This
results in cash flows from the financial markets to the firm (A) . This cash is invested in the investment activities
(assets) of the firm (B) by the firm’s management. The cash generated by the firm (C) is paid to shareholders and
bondholders (F) . The shareholders receive cash in the form of dividends; the bondholders who lent funds to the firm
receive interest and, when the initial loan is repaid, principal. Not all of the firm’s cash is paid out. Some is retained
(E) , and some is paid to the government as taxes (D).
Figure 1.3
Cash Flows between the Firm and the Financial Markets
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Over time, if the cash paid to shareholders and bondholders (F) is greater than the cash raised in the financial
markets (A) , value will be created.
Identification of Cash Flows
Unfortunately, it is sometimes not easy to observe cash flows directly. Much of the information we obtain is in the
form of accounting statements, and much of the work of financial analysis is to extract cash flow information from
these statements. The following example illustrates how this is done.
EXAMPLE 1.1
Accounting Profit versus Cash Flows The Midland Company refines and trades gold. At the end of the year, it
sold 2,500 ounces of gold for $1 million. The company had acquired the gold for $900,000 at the beginning of the
year. The company paid cash for the gold when it was purchased. Unfortunately it has yet to collect from the
customer to whom the gold was sold. The following is a standard accounting of Midland’s financial circumstances
at year-end:
The Midland Company Accounting View Income Statement Year Ended December
31
Sales $1,000,000
−Costs − 900,000
Profit $ 100,000
By generally accepted accounting principles (GAAP), the sale is recorded even though the customer has yet to pay.
It is assumed that the customer will pay soon. From the accounting perspective, Midland seems to be profitable.
However, the perspective of corporate finance is different. It focuses on cash flows:
The Midland Company Financial View Income Statement Year Ended December 31
Cash inflow $ 0
Cash outflow − 900,000
−$ 900,000
The perspective of corporate finance is interested in whether cash flows are being created by the gold trading
operations of Midland. Value creation depends on cash flows. For Midland, value creation depends on whether and
when it actually receives $1 million.
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Timing of Cash Flows
The value of an investment made by a firm depends on the timing of cash flows. One of the most important
principles of finance is that individuals prefer to receive cash flows earlier rather than later. One dollar received
today is worth more than one dollar received next year.
EXAMPLE 1.2
Cash Flow Timing The Midland Company is attempting to choose between two proposals for new products. Both
proposals will provide additional cash flows over a four-year period and will initially cost $10,000. The cash flows
from the proposals are as follows:
Year New New
Product A Product B
1 $ 0 $ 4,000
2 0 4,000
3 0 4,000
4 20,000 4,000
Total $20,000 $16,000
At first it appears that new product A would be best. However, the cash flows from proposal B come earlier than
those of A. Without more information, we cannot decide which set of cash flows would create the most value for the
bondholders and shareholders. It depends on whether the value of getting cash from B up front outweighs the extra
total cash from A.
Risk of Cash Flows
The firm must consider risk. The amount and timing of cash flows are not usually known with certainty. Most
investors have an aversion to risk.
EXAMPLE 1.3
Risk The Midland Company is considering expanding operations overseas. It is evaluating Europe and Japan as
possible sites. Europe is considered to be relatively safe, whereas operating in Japan is seen as very risky. In both
cases the company would close down operations after one year.
After doing a complete financial analysis, Midland has come up with the following cash flows of the alternative
plans for expansion under three scenarios—pessimistic, most likely, and optimistic:
Pessimistic Most Optimistic
Likely
Europe $75,000 $100,000 $125,000
Japan 0 150,000 200,000
If we ignore the pessimistic scenario, perhaps Japan is the best alternative. When we take the pessimistic scenario
into account, the choice is unclear. Japan appears to be riskier, but it also offers a higher expected level of cash flow.
What is risk and how can it be defined? We must try to answer this important question. Corporate finance cannot
avoid coping with risky alternatives, and much of our book is devoted to developing methods for evaluating risky
opportunities.
