Hi. Welcome back to Finance for Non-Finance Professionals. This week, we're talking about cash creation and our measure of free cash flow. And what we've been doing is walking through each part of that formula, walking through the financial statements, and figuring out where all the cash is hidden. In this lesson, we're going to talk about salvage or terminal values-- what happens when we sell assets on the balance sheet. OK, we talked in the last lesson about capital expenditures and how that spending cash that doesn't get reflected in earnings or profit. Selling assets generates cash. It's sort of the opposite of capital expenditures. When I sell assets, that generates cash, but that cash also isn't reflected in the regular sort of income statement, profit and loss. It's not reflected in earnings. We need to go back and add back the money that we generate after taxes from anything that we've sold. Asset sales have to go into our measure of free cash flow. OK, why do we have to do this? Well, the balance sheet-- sometimes it's easy to look at a financial statement and it just looks like a bunch of numbers in a table-- but a balance sheet is a real thing. The assets on the balance sheet represent real physical property, plant, and equipment. When a machine is written down as a long term asset on a balance sheet, there is a machine, a physical piece of metal someplace, in some factory, somewhere, that doesn't just evaporate when the project is finished. Everything on the balance sheet represents a real asset that's somewhere. That physical thing exists. We have to make sure that we're cleaning up after ourselves. In a sense, when children are done playing, they have to put away their toys-- we have to put away all of our assets when we're finished with a project or evaluation. We have to make sure the property, plant, and equipment doesn't just vanish or evaporate, pop up like mushrooms, or go away like dust in the wind. We have to make sure that our balance sheet sweeps clean, that we've accounted for all of the assets when we finish a project. So the balance sheet has to sweep clean. That means we have to sell off everything that's left on the books at the end of a project. We've got to make sure that we're accounting for terminal values. When the project is finished or the valuation is ended, we've got to make sure that we're accounting for all the assets that are left on the balance sheet. OK, let's walk through a really simple example. I've got a very simple balance sheet listed for you here. And so I've got cash and marketable securities in each of three years-- 75, 75, and 200, other current assets, and then I've got fixed assets at cost. Now it looks like I spent, in year zero, $500 to buy an asset. That $500 that I spent gets kept at cost at $500 because that's how much I spent. But what's going to happen to the value of that asset over time? According to this balance sheet, it's going to decline by $100 each period because there's depreciation. So there's my first depreciation of $100, there's my second depreciation, $200. That depreciation accumulates each period, as each period I take a $100 depreciation expense. Now what does that leave me with? That leaves me with what we call net fixed assets-- that's fixed assets at cost minus the accumulated depreciation. In other words, what's the economic value of that asset on the balance sheet once I've accounted for the fact that it's deteriorated a little bit? Well, in year one, that $500 has gone down by $100 to give a net fixed assets of $400. In year two, the $500 has gone down by a total of $200, so it leaves me with a net fixed asset of $300. This is the number right here, the ending net fixed asset, that I need to account for as a terminal value or a salvage value when I clean up the project. That's the number to focus on, the last balance sheet at the end of the project. In this case, it's at the end of year two. I've got an asset, net fixed assets, that's worth $300 that I have to sweep clean. I've got to do something with it. Maybe I'm going to give it to another division. Maybe I'm going to continue to use it in more years of the project. But if I'm only doing a two year valuation on the project, I can't pretend that that $300 of net fixed assets at the end of the project just kind of disappears or goes someplace else or nothing happens to it. I've got to either sell it and account for the sale, or I've got to continue to use it and account for it in more columns of the project. But I can't simply ignore it. I've got to account for the terminal or salvage value at the end of the project. OK, what if I have no plans to sell the asset? It doesn't matter. Assets are still an opportunity cost. Even if I was going to take that asset and I was going to burn it, I still have to account for the fact that that asset is a real asset, in the last example, worth $300, that I could pay out to investors. Maybe I'm going to use that asset and I'm going to deliver that machine to another division or another factory. That's fine. But I have to make that factory pay for it. In other words, that factory, when I move that asset over, it's like they're going to buy it from my firm, they're going to buy it from my project. Moving that asset has a cost, and each project has to be separate. So even if I am going to give that asset to my friend or give it to another factory, I've got to make them pay for it. That's really what we call-- in accounting it's a huge area of research and activity called transfer pricing, moving assets within the firm. I've got to account for the fact that I'm moving that asset. Each project really has to be stand alone and justify the use of the asset. So the best practices for capital budgeting and creation of free cash flow measures always sweeps clean the balance sheet. Even if I have no intention of selling the asset, I have to pretend at the end of the project like I'm going to to reflect the real opportunity costs of the tax effects of moving that asset within the firm. OK, getting back to our measure of free cash flows, we're pretty much done now. We take operating profit after tax, we subtract the increase in working capital, add back depreciation, subtract out capital expenditures, and now we'll add back any after tax salvage or terminal values. That's it. That's our measure. That's our treasure hunt through all the financial statements, the income statements, the balance sheets, the statement of cash flows. We can get to a measure of real cash creation by doing these five things carefully. To sum up, asset sales have to be included in our measure of free cash flow. Even if I'm not going to sell the asset, I've still got to include it in my free cash flow measure. "The balance sheet always has the sweep clean" is another way of saying I have to make sure that I'm selling everything at the end of the project. Each project has to stand alone. Even if I'm not selling it, if I'm giving it to another project or moving it to another division, I've got to let that division or that project justify the use of the asset with their own NPV and their own IRR. My IRR and NPV have to reflect the fact that my balance sheet sweeps clean. Opportunity costs are key. If I'm going to use that asset, I've got to reflect both its purchase up front and its sale at the end through the terminal or salvage value.
