FREE online courses on Financial Management and Creating Value - Chapter 3 -
Residual Cash Flow
The third and final approach to measuring value that we need
to discuss (and yes I saved the best for last) is Residual Cash Flow. Residual
Cash Flow (RCF) is sometimes called Cash Value Added (CVA); i.e. what are the
residual cash flows generated by this investment. Residual Cash Flow is net cash
flows less a charge for cost of capital. We can express Residual Cash Flow (RCF)
as:
RCF = Adjusted Operating Cash Flows - I (Gross Investment)
I: Cost of Capital
Example 3 - Calculate Residual Cash Flow
A capital asset costing $ 100,000 has a useful life of 5
years with no salvage value. The asset will depreciated over the straight-line
method. Annual cash flows from this investment are $ 35,000 per year and the
marginal tax rate is 35%. The weighted average cost of capital is 8.5%. What is
the RCF per year?
Cash Flow per Year
$ 35,000
Less Taxes @ 35% (12,250)
Net Cash Flows 22,750
Adjustment to Cash Flow (1) 7,000
Adjusted Cash Flow 29,750
Less Cost of Capital (2) ( 8,500)
Residual Cash Flow (RCF) per Year $ 21,250
(1) depreciation of $ 20,000 per year ($100,000 / 5 years) x
.35 tax rate.
(2) gross investment of $ 100,000 x 8.5%.
As you can see from the previous example, RCF is much easier
to calculate when compared to EVA or CFROI. However, we want RCF to be as
accurate, if not more so, than EVA and CFROI. Therefore, we will need to make
some additional adjustments. We can take a page out of the EVA book and apply it
to RCF. For example, research and development expenses are capitalized under EVA
since they provide future economic benefits. This same type of adjustment should
be made to operating cash flows under RCF.
We should also remember that weighted average cost of capital
includes the cost of debt. If operating cash flows include interest payments,
then interest should be ignored in arriving at operating cash flows. Otherwise,
you will double account for debt service costs, once in calculating cash flow
and once in calculating a charge for cost of capital. As you might expect, in
the hands of consultants RCF is subject to several other adjustments. Two
notable examples are summarized below:
Calculating RCF per The Boston
Consulting Group:
- In arriving at adjusted operating cash flows,
economic depreciation is deducted. Economic depreciation refers to the sinking
fund amounts required along with earned cost of capital that is required to
replace the asset.
- Similar to CFROI, adjusted operating cash flows
are restated to constant dollars.
- Weighted average cost of capital is ignored and a
market driven rate is used. The market driven rate is estimated as the discount
rate for equating the present value of net cash flows for an index of companies
with the sum of prices for debt and equity of the same index of companies. The
market driven rate is essentially the rate of return demanded in the
marketplace.
Calculating RCF per Fredrik Weissenrieder Consulting:
- Adjusted operating cash flows are calculated by
finding the discounted cash flow that provides a Net Present Value of zero for
the economic life of the investment.
- Gross investment excludes non-strategic assets.
Investments made that have nothing to do with returns (such as furniture and
fixtures) are not part of capital.
Residual Cash Flow incorporates residual income concepts and
gets back to the most important indicator - operating cash flow. By focusing on
operating cash flows, RCF simplifies the valuation process and still retains
high degrees of accuracy. This point was made clear when 325 companies were
compared over a five-year period using EVA, CFROI, and RCF. The study, published
in the October 1998 issue of Management Accounting, concluded the following:
"EVA's creators have certainly made some incredible claims,
but so far the academic testing of the measure has not shown significantly
different results from residual income in most respects. Clearly the superiority
of RCF is apparent over either EVA or CFROI, the recently popular measures
produced by the consulting firms."
Residual Cash Flow does have some drawbacks, but they are
few. For example, RCF is not a comparable form of measurement; i.e. you can not
compare RCF's between companies. In addition, RCF is sometimes more appropriate
for project evaluation rather than company valuation. However, given the fact
that RCF is highly correlated to stock prices, it warrants serious consideration
by all organizations concerned about measuring value.
