Difficulty: Intermediate | Prerequisites: Units 8–10 (plant assets, depreciation, cost classification, budgeting), basic understanding of the time value of money.
These three units bring the course full circle. Unit 11 introduces capital budgeting, the framework for evaluating long-term investments using the time value of money (NPV, IRR). Unit 12 covers the statement of cash flows, which reconciles net income to actual cash movement and classifies every cash transaction as operating, investing, or financing. Unit 13 addresses performance analysis from both a management perspective (variance analysis) and an investor/creditor perspective (return on equity, EBITDA, interest coverage, leverage ratios). Together, these units connect the dots between cost measurement, planning, and evaluation.
Capital budgeting uses discounted cash flow techniques (NPV and IRR) to decide whether a long-term investment is worth making. The statement of cash flows shows where a company's cash came from and where it went, split into operating, investing, and financing activities, most commonly using the indirect method (start with net income and adjust for non-cash items). Performance analysis uses ratios like return on equity, interest coverage, leverage, and tangible net worth to assess how well a company is doing and how safe it is to lend to.
Capital budgeting
A framework for evaluating long-term investment decisions that explicitly incorporates the time value of money.
Think of it as: the process of deciding whether a big purchase (a machine, a building, a project) will pay for itself and then some.
Net present value (NPV)
The total present value of all cash flows (inflows and outflows) associated with a project. If NPV is positive, the investment is worth making. Most widely used DCF method.
Internal rate of return (IRR)
The discount rate at which a project's NPV equals zero. If the IRR exceeds the company's cost of capital, the project is financially attractive.
Discount factor (present value factor)
The multiplier used to convert a future cash flow to its present value. It decreases as you move further into the future. Equals 1 / (1 + r)^t.
Net cash flow (NCF)
The difference between cash inflows and cash outflows in a given period.
Depreciation tax shield
The tax saving produced by the depreciation deduction. Equals Tax Rate x Depreciation Deduction for that year.
Statement of cash flows
A financial statement that reports all cash inflows and outflows during a period, classified as operating, investing, or financing activities.
Direct method
Reports cash from operations as Cash In minus Cash Out. Less commonly used.
Indirect method
Starts with net income and adjusts for non-cash items (depreciation, gains/losses) and changes in current assets and liabilities to arrive at cash from operations. Most widely used.
Variance
The difference between an actual result and a budgeted amount.
Return on equity (ROE)
Net Income / Beginning Owner's Equity. Measures how much profit the company generates per unit of owner investment. Higher is better.
EBITDA
Earnings Before Interest, Taxes, Depreciation, and Amortization. A proxy for cash flow from operations. EBITDA = Earnings + Interest + Tax + Depreciation + Amortisation.
Tangible net worth
(Assets - Intangible Assets) - Total Liabilities. Measures the tangible equity backing the business. Higher is better.
Leverage ratio (debt-to-asset ratio)
Total Liabilities / Total Assets. Measures how much of the company is funded by creditors. Lenders prefer a low number; owners may prefer a higher one.
Capital budgeting handles long-term investment decisions where the time value of money matters. Operating budgets (Unit 10) are short-term plans that treat capacity as fixed.
Initial outlay: costs of acquiring the resource and making it ready for use. If an old asset is being replaced, the proceeds from selling it reduce the initial outlay.
Estimated life and salvage value: how long the asset will serve, and what it can be sold for at the end.
Timing and amounts of operating cash flows: expected revenues, cost savings, and operating expenses each year.
Cost of capital (discount rate): the opportunity cost of the capital required for the investment.
Net Present Value (NPV): discount all future cash flows back to the present at the company's cost of capital, then sum them. A positive NPV means the investment earns more than its cost of capital. NPV is the most widely used method.
\text{PV of a cash flow} = \frac{\text{NCF}_t}{(1 + r)^t}\text{Discount Factor} = \frac{1}{(1 + r)^t}Higher discount rates produce lower NPVs.
Internal Rate of Return (IRR): the discount rate that makes NPV equal to zero. Accept the project if IRR > cost of capital.
\text{FV} = \text{PV} \times (1 + R)^n\text{PV} = \frac{\text{FV}}{(1 + R)^n}Depreciation is a non-cash expense that reduces taxable income. The tax saving it produces each year is the depreciation tax shield.
\text{Depreciation Tax Shield} = \text{Tax Rate} \times \text{Depreciation Deduction}This shield is a real cash benefit and must be included in the project's cash flow analysis.
The statement of cash flows tells investors, creditors, and other users four things: the entity's ability to generate future cash flows, its ability to pay dividends and meet obligations, the reasons for the difference between net income and net cash from operations, and the investing and financing transactions during the period.
Direct method: Cash In minus Cash Out. Straightforward but less commonly used.
Indirect method (most used): Start with net income, then adjust.
Add back depreciation and amortisation (non-cash expenses)
Add or subtract losses/gains on sales of assets
Adjust for changes in current assets and liabilities
Both methods arrive at the same cash from operations figure.
Worked example:
Income statement: Revenue $100, Cash Expenses $70, Depreciation $12, Net Income $18.
Direct: Cash In $100 - Cash Out $70 = Change in Cash $30.
Indirect: Net Income $18 + Depreciation $12 = Change in Cash $30.
Current assets: an increase is subtracted from net income in the indirect section (cash was used but not expensed). A decrease is added back (cash was received but not recognised as revenue).
Current liabilities: an increase is added back (expense was recognised but cash was not paid). A decrease is subtracted (cash was paid but not expensed).
Operating activities: cash effects of transactions that create revenue and expenses. Income statement items.
Investing activities: acquiring and disposing of investments, property, plant and equipment; lending money and collecting loans. Changes in long-term asset items.
Financing activities: obtaining cash from issuing debt and repaying it; obtaining cash from shareholders, repurchasing shares, paying dividends. Changes in long-term liabilities and equity.
The sum of operating, investing, and financing sections equals the net increase or decrease in cash for the period.
Change in Assets - Change in Liabilities = Change in Paid-in Equity + Revenues - Expenses
Expanding assets into cash and non-cash:
Change in Cash = Change in Liabilities - Change in Non-Cash Assets + Change in Equity + Revenues - Expenses
Three major steps:
Convert net income from accrual to cash basis (the indirect method adjustments)
Analyse changes in non-current asset and liability accounts to classify as investing or financing
Verify that the net change in cash on the statement matches the change in the cash account on the balance sheet
Sources: comparative balance sheets, the current income statement, and additional transaction data.
A variance is the difference between an actual result and a budgeted amount. Management uses variances to identify problems and opportunities.
Investors and creditors evaluate a company by asking three questions:
How did the company perform this year compared to last year?
Does the owner have enough investment in the company to cushion the loan?
Will the company take on more debt, potentially weakening its ability to repay?
Return on Equity (ROE)
ROE = Net Income / Beginning Owner's Equity
Measures the return generated on the owner's investment. Higher is better.
Interest Coverage Ratio
Interest Coverage = EBITDA / Interest Expense
Answers: "How many times can the company cover its interest obligations from the cash flow it generates?" Higher is better.
EBITDA
Earnings Before Interest, Taxes, Depreciation, and Amortisation.
EBITDA = Earnings + Interest + Taxes + Depreciation + Amortisation
A commonly used proxy for operating cash flow.
Tangible Net Worth
Tangible Net Worth = (Assets - Intangible Assets) - Total Liabilities
Measures the hard-asset equity backing. Higher is better.
Net Assets Ratio
Net Assets Ratio = Total Liabilities / Tangible Net Worth
Lower is better from a creditor's perspective.
Leverage Ratio (Debt-to-Asset Ratio)
Leverage Ratio = Total Liabilities / Total Assets
Answers: "How much of the company is funded by creditors?" Lenders want a small number (lower risk); owners may prefer a larger one (more leverage on their equity).
\text{PV} = \frac{\text{NCF}_t}{(1 + r)^t}\text{Discount Factor} = \frac{1}{(1 + r)^t}\text{FV} = \text{PV} \times (1 + R)^n\text{Depreciation Tax Shield} = \text{Tax Rate} \times \text{Depreciation Deduction}\text{Cash from Operations (Indirect)} = \text{Net Income} + \text{Depreciation} \pm \text{Gains/Losses} \pm \Delta\text{Current Assets \& Liabilities}\text{ROE} = \frac{\text{Net Income}}{\text{Beginning Owner's Equity}}\text{Interest Coverage} = \frac{\text{EBITDA}}{\text{Interest Expense}}\text{EBITDA} = \text{Earnings} + \text{Interest} + \text{Tax} + \text{Depreciation} + \text{Amortisation}\text{Tangible Net Worth} = (\text{Assets} - \text{Intangible Assets}) - \text{Total Liabilities}\text{Net Assets Ratio} = \frac{\text{Total Liabilities}}{\text{Tangible Net Worth}}\text{Leverage Ratio} = \frac{\text{Total Liabilities}}{\text{Total Assets}}Students often forget that depreciation is a non-cash expense. It does not involve any movement of cash, which is why it is added back to net income in the indirect method.
A positive NPV does not mean the project generates no risk. It means the expected return exceeds the cost of capital. The discount rate should already reflect the project's risk.
Students sometimes confuse operating, investing, and financing activities. A good rule: if it touches the income statement, it is operating; if it involves long-term assets, it is investing; if it involves long-term debt or equity, it is financing.
EBITDA is not the same as cash flow. It is a proxy. It ignores changes in working capital, capital expenditures, and tax payments.
⚠️ Be able to compute NPV given a set of cash flows and a discount rate. Know how to apply the discount factor year by year.
⚠️ Understand the depreciation tax shield and be able to calculate it for a given year.
⚠️ The indirect method for cash from operations is heavily tested. Practice starting from net income and making each adjustment.
⚠️ Know how to classify any transaction as operating, investing, or financing.
⚠️ Current asset increases are subtracted (not added) in the indirect method. This trips up many students.
⚠️ Be ready to compute and interpret ROE, interest coverage, and leverage ratio. Know which direction is "better" for each and from whose perspective (owner vs lender).
True or False: A project with a negative NPV should be accepted if its IRR is positive. (False. The IRR must exceed the cost of capital, not merely be positive.)
Fill in the blank: In the indirect method, depreciation expense is ________ to net income. (Added back)
True or False: Buying equipment is classified as an operating activity. (False. It is an investing activity.)
Fill in the blank: The leverage ratio equals Total Liabilities divided by ________. (Total Assets)
True or False: An increase in accounts receivable is added to net income in the indirect method. (False. It is subtracted, because revenue was earned but cash was not received.)
Q: A project requires a $50,000 initial outlay and generates net cash flows of $15,000 per year for 4 years. The cost of capital is 10%. The discount factors for years 1–4 at 10% are 0.909, 0.826, 0.751, and 0.683. What is the NPV?
A: PV of cash flows = 15,000 x (0.909 + 0.826 + 0.751 + 0.683) = 15,000 x 3.169 = $47,535. NPV = 47,535 - 50,000 = -$2,465. The project should be rejected.
Q: A company has net income of $40,000, depreciation of $8,000, and accounts receivable increased by $3,000 during the year. What is cash from operations under the indirect method?
A: 40,000 + 8,000 - 3,000 = $45,000.
Q: Classify the following: a company issues bonds for $500,000.
A: Financing activity (issuing debt).
Q: A company has EBITDA of $120,000 and interest expense of $30,000. What is the interest coverage ratio?
A: 120,000 / 30,000 = 4.0 times.
Q: A company has total assets of $800,000, intangible assets of $50,000, and total liabilities of $300,000. What is its tangible net worth?
A: (800,000 - 50,000) - 300,000 = $450,000.
Q: Using the same figures, what is the leverage ratio?
A: 300,000 / 800,000 = 0.375 (or 37.5%).
Capital budgeting (Unit 11) relies on depreciation methods from Unit 8 to compute the depreciation tax shield. The choice of depreciation method (straight-line vs accelerated) directly affects the timing of tax savings and therefore the NPV of a project.
The statement of cash flows (Unit 12) ties back to budgeting (Unit 10): the cash budget estimates future cash flows, while the statement of cash flows reports actual cash flows. Comparing the two is a form of variance analysis.
Performance ratios (Unit 13) draw on figures from both the income statement and the balance sheet. Understanding how product costs, period costs, and depreciation flow through these statements (Units 8–9) is essential for interpreting what the ratios are telling you.
capital budgeting, time value of money, net present value, NPV, internal rate of return, IRR, discounted cash flow, DCF, discount factor, present value factor, net cash flow, NCF, initial outlay, salvage value, cost of capital, discount rate, depreciation tax shield, future value, present value, statement of cash flows, cash flow statement, direct method, indirect method, operating activities, investing activities, financing activities, net income adjustments, depreciation add-back, current asset changes, current liability changes, accrual to cash, variance, variance analysis, return on equity, ROE, EBITDA, earnings before interest taxes depreciation amortisation, interest coverage ratio, tangible net worth, net assets ratio, leverage ratio, debt-to-asset ratio, creditor analysis, passive investor, financial ratios, managerial accounting, cost accounting, UT Austin