[MUSIC] Before beginning this video, if you haven't had a chance to see Money Flows, Follow Ideas in course one of this specialization, I encourage you to do so since this will give you some important background on big picture questions about cash flows. In a broad sense, think of Cash Flow as essential nutrients that sustain an economic system. A healthy system consisting of households, organizations and governments constantly generates new cash flows which sustain productivity, employment and wealth creation. The biggest danger for any of the sectors in the system is declining revenues since revenues are the most important source of cash flow. For individuals, declining revenues means losing jobs and consequently, income. For organizations, it means a decline in demand for goods and services, which reduces sales revenue and therefore profits. And for the government, lower revenues means less money is collected in taxes, which translates to less cash in the budget to spend on crucial services. The hard truth about cash flow, by which I literally mean money in and money out of our pockets, is how profoundly it affects our standard of living, our life choices, and our identities. People, farms, and governments stand to lose a lot when the cash flow tabs are turned off. This is why so much of their energy goes towards ensuring that the life brought cold cash flow continues to circulate. To help us understand these points in more detail, we need to look more closely at how economic actors manage the problem of cash flow. First, we'll look at a profit seeking firm. Even though our assumptions can also apply in other settings. To start, one thing common to all firms is the bottom line. The bottom line for most is profit. However, profit is derived from an accounting framework. And accounting numbers aren't the same as cash flow. Simply stated, the common language that all firms really understand is the quest to generate cash flow. This raises important questions about how much and when the cash flow comes in to sustain the firm's operations. But cash flow must also meet the needs of two groups who supply money to the firm and one of these groups are bondholders who look for contractual interest payments for their loans while the other group are stockholders, who collectively own the firm and that for riskier dividends as well as price appreciation. Given the importance of cash flows, let’s explore how their create, counted and evaluated. Before naming the components that comprise cash flows, it's what spending some time understanding a few critical assumptions that are the basis of all cash flow forecast. These assumptions are essential, because they provide the rationale behind what is going to be counted. The most important assumptions include the standalone principle, incremental thinking, a focus on cash, the inclusion of opportunity cost, and the exclusion of sunk costs and financing costs. Let's take a closer look at each one of these. The Stand-Alone Principle forces us to think about investment projects as if they were an entity on its own, standing on its own feet like a mini firm and not dependent on displacing value that all ready exists on the firm. To better understand The Stand-Alone Principle, let's consider the following example. Your firm wants to expand its line of snack related foods. It develops a product called Beet-It, which is a preservative free mixture of organic root juice derived from beets, mixed with honey, nuts, and Dahi that is going to complete the firms growing and lucrative food business segment. That recipe might just turn into an amazing snack, and I'm about ready to taste it just about now. But back to the standalone assumption. This should value beet-it as a subset, independent of the cash flows and values generated by other businesses the firm is in. In other words, beet-it's cash flows and value must be separately identified and added or subtracted, from the values of all the rest of the firm’s projects, even if the other projects are interdependent or compete with Beet- it. The key question is whether cash flows can be directly attributed to the Stand-Alone Project, since ultimately, its value will contribute, or reduce the sum of the values, of all other existing projects of the firm that also stand alone. In practice, the standalone assumption influences how the divisions, business units, and functional areas we see within companies are created. For example, take Nestle, the world's largest food and beverage company. Not only does it have geographic divisions that are responsible for generating cash flow to the parent company, but it's business units like beverages, food, nutrition, pharma, and so on, are rewarded for their various cash flow contributions. You would likely discover further groups working in production, in marketing, IT, and finance, and so on. And all of this is to say that Nestle's divisions, business units, and functional areas, are responsible to monitor and constantly create new projects to compete to keep market share and create positive values Of course cash flow enables it to do all of that. The next two critical assumptions ask us to think incrementally and to focus on cash as we calculate values that change. This means measuring how your cash position changes if you do a project versus if you don't. Returning to the example of beet it, we are not so much interested in looking at what the firm's cash flows were in aggregate before this idea or what they will be after the idea nor are we interested in averages that distort the size and timing of cash flows. Instead we're interested in looking at the incremental cash flow, which can be defined as the difference between do minus don't. That is understanding how cash flows will change as a result of doing beet it versus not doing it. Notice as well an emphasis on cash as in real money in and out of your pocket. Now accounting frameworks are confusing in this regard because they mix non cash items, like receivables, which assume that customers will pay in the near future, with cash that has all ready been paid. In fact, receivables will have the opposite effect on cash flows. For example, assume beet-it recorded its sales to include both cash and receivable components like most funds do. The problem with the receivables, also known as credit sales, are that they reduce cash flow. Because the firm has actually invested the cash with the customer until the customer pays. Receivables are therefore an outflow of cash, even though they are reported as sales, which most will assume is a cash inflow. Therefore, it's really important to focus on the cash portion of the sales only. There receivables are part of working capital which ties up cash that the firm just can't use until the customer pays the firm. Therefore, thinking in terms of cash is very helpful to know what you have in hand, as opposed to what you may have in the future. This might also explain why many small businesses that have great ideas and healthy sales still have problems with cash flow, to the point of threatening their survival, because their significant working capital needs can use up almost all of their cash. So despite lines of credit from banks, business failure is often a result of not enough cash flow even though sales are positive and the product is great. The third assumption includes opportunity costs which can be a difficult concept to grasp. This is because an opportunity cost is associated with foregoing the next best alternative. And since every decision has an alternative, that we can forego, it becomes difficult to keep track of opportunity costs. Still by looking at a few examples of opportunity costs that are typically overlooked we get into the habit of thinking about them which makes for a more accurate estimation of cash flow. The most basic way of considering the opportunity cost for a project is to consider the next best alternative in terms of generating cash; of doing something else with the resources that would be required for the project. Let's go back to our example. Suppose we plan to produce beet-it in a new facility that will be built on existing land that our firm already owns. If we think incrementally, we go through with the project. Cash is not implicated, since we all ready own the land. However, if we don't do the project and find the land could be sold, at say for $1 million, we should factor that amount into the costs of Beet It, because the firm would otherwise forgo this cash flow by going ahead with the Beet It project. In fact, all existing resources, whether these are assets or whether their people should have a value. Otherwise they wouldn't be a resource. So they should be factored into the cost of the beet-it project. When you hear the economists talk about the no free lunch principle, this is the sort of thing they have in mind. Opportunity cost. Since they're implying that nothing comes for free. Continuing with our example, suppose Beet-it shares space in a new production facility. The other project might be asked to share some of the fixed costs, which are costs that remain the same regardless of the quantity of goods or services provided, things like paying rent or your utilities expenses should fixed costs be considered and therefore reduce the projected cash flows of going ahead with the beet-it project. On the other hand, if the firm would have paid for these fixed costs, whether it proceeded with the beet-it project or not there are no incremental amounts involved, so, we would not charge beet-it with these fixed costs. But if the increases in fixed costs can be directly attributed to beet- it, those amounts should be charged to the project. The other obvious opportunity caused would be to displace sales of existing products produced by a firm, process also known as the Cannibalization or erosion of existing sales. This might occur is consumers substitute beet it for another product line that the firm is currently selling. Again, in this case, beet it should be charged with the estimated cost of the erosion if it's going to cause that erosion. A number that will likely be derived from marketing studies. Finally, the last set of assumptions explain why sunk costs and financial costs should be excluded. Examples of sunk costs are the research and development expenditures that went into conceiving beet it or, for example, the marketing study that suggested there would be sales substitution also known as erosion. However, all of these cost represent cash outflows that are all ready paid or sunk before the project was evaluated. Determining when a cash flow should be considered sunk relates to what stage the project is at. For instance, if the project is ready to be formally evaluated as a proposal, typically before it's manufactured or before services are produced, all historical costs are sunk and, therefore, irrelevant. This is because the expenditures cannot be undone. So, at this stage we instead focus on anticipated future cash flows. Financing cost are also traditionally excluded from calculating cash flows. The two biggest financing costs are interest on borrowed money, bonds, and dividends on equity funds or stocks. We include these costs not because we won’t pay them, but because they are included in calculating the discount rate which is explained in detail later in this course. So for now, we simply want to avoid double counting. So let me summarize, the main assumptions that drive the calculations for cash flow are The stand alone principal, thinking incrementally, focusing on cash, the inclusion of opportunity costs, and the exclusion of sunk and financing costs. As mentioned, these assumptions are essential to framing the rationale behind what is included, or what is excluded, in the calculation of cash flow. And robust calculation of this sort are the best defense against challenges from those who want to come in between your idea and his implementation
