Module 7: Supply Chain Finance II

In this course, we will consider how to use the tools of finance to evaluate our supply chain designs and initiatives. It’s important to use the tools of finance because we want to communicate the value that we are creating, as supply chain professionals, within the firm. And if we use the same tools for evaluating our supply chain designs and initiatives, then our colleagues in finance will understand them better and we’ll be able to communicate the value all the way up to the CFO and the CEO.

The way that they evaluate decisions, specifically investment decisions within the firm, how to allocate capital to different initiatives, is using a tool called discounted cash flow analysis. It’s a very standard tool used in finance. We’re going to consider how to use it for various supply chain examples and in the way we design our supply chains. So the investment decisions that we can make using this tool can range from actually that the investors in our firm would use discounted cash flow analysis to determine whether to buy our stock. The CEO uses the same tools so that the CEO can make sure that he or she is delivering value to those investors. But you can also use this discounted cash flow analysis in your own finances. For example, when I decided to put solar panels on my roof, I used the same discounted cash flow analysis and it’s worked out well. So let’s think about the investment decisions we’re going to be making, but we have to start by articulating the cash flows that go into those decisions. And we’ll think about different kinds of cash flows. We’ll have projected cash flows. We’ll have what we call free cash flows. It’s not free money, but it’s what’s free for the firm to invest. And then we have to think about what are the relevant cash flows, especially for the supply chain decisions that we’re going to be making. So projected cash flows, we have to think about going forward in time. So we’ll think about period one, period two, period three, to periods often years, one year, two years, three years, and we’ll try to accumulate the cash flows over that year and think about them, one, two, three years out.

We also have to consider the upfront cash flows and a lot of times those are our investments. So we’ll call that period zero. At the end of period zero, which is right now, we’ll make those investments. And we want to think about how long that time horizon is. And let’s say in this case, we’re going to go four years. So in the fourth year we’ll call it capital T for that end of period that we’re considering in terms of cash flows. When we think about the cash flows we have to think what goes into those and that’s where we think about our free cash flows here. And here’s a formula for free cash flows that you’ll get more into in the lesson here. But that summarizes the key investments and returns related to our investment decision. So we have capital expenditures. This is what’s very commonly where they will commonly use discounted cash flow analysis in a firm is for capital expenditure decisions and some of you may have gone through that kind of a process. So we’ll call that Capex and we have to think about it time T. A lot of time, again, it’s in period zero, but we could have capital expenditures for fixed assets, like warehouses and trucks over time as well. So that fits into the rate there, Capex t. We’ve got working capital, which is the combination of our receivables, our payables, but most importantly for us in supply chain, inventory. And that investment of working capital could be throughout the period as well. And we want to think about working capital, we always have to have working capital in the firm, but we want to think what is the net working capital and how is it changing over time. So we want to think about the delta, the change in what we call net working capital for each period. And we’ll get into what that is. But we see that down here, too. So in our free cash flows, we’re subtracting out these investments. What are our returns? Well we have revenue, we have expenses. We have to consider depreciation of these capital expenditures and we always have to consider taxes. They can make or break an initiative. Not considering taxes properly can really distort your investment decision. So with revenue and expenses, we will combine those into what’s called EBIT, earnings before interest and taxes, and we’re doing that for every period T. Hopefully, those EBITS will be really positive to offset the investments. We have to consider the depreciation here, which down here is DA, depreciation and amortization. We mostly have depreciation and so that’ll be over time as well. We’ll depreciate those capital investments. And then taxes. We consider taxes by looking at the tax rate and we’ll apply it to our profits, our EBIT, where we subtract depreciation because we get a tax shield for that. But note down here, we have to add it back in. Why is that? Because depreciation is not really cash. We’ve spent the cash up front. We want to account for the taxes, but we don’t want to have it distorting the cash flows because we’re not actually paying out the depreciation over time. So it’s an important adjustment in our free cash flows. And that brings us to this point. I didn’t put an E here on the tax rate, so we’ve got to consider the full tax rate. That brings us to the important point of what’s relevant. Depreciation and amortization is not a relevant cash flow over time. It’s part of, it’s embedded in our capital expenditures, but it’s not a cash inflow from the income statement that we should consider over time. We have to add it back in to make sure we offset that adjustment we make in our EBIT because it’s included in EBIT. So we have to consider a lot of these kinds of decisions of what’s relevant and there’s two principles we’ll use in doing that. There’s a cash flow principle. We have to make sure cash is actually moving. And in the case of depreciation, it’s an accounting number that where cash is not being spent over time. It’s accounting for the upfront cost. And the second principle is with and without. With and without our investment decision, we have to consider the cash flows that are relevant. Once we’ve got our cash flows together, then we move over to think about our investment decision. We have to consider the time value of money because $1 today is worth more than $1 in the future because we can invest it. And there’s less risk of cash flows in the future not happening. So we want to think about the time value of money. And we’ll have what we call a discount rate. We’ll discount those future cash flows according to the returns we can get by investing money today. So the discount rate we call r. And the time value of money for any, for cash in any period T, a cash flow period T, we’d have to divide it by 1 plus r to the power of T, to discount it to be and that’s equal to our cash and present value.

So bringing a future cash flow to the present value is a key part of discounted cash flow analysis. Some of these cash flows may not end in period T. They may be what we call a perpetuity, something that would be forever. For example, if you find a new inventory policy to reduce the inventory and it would stay that way as long as you keep the policy in place, that’s a perpetuity. Well, how do we account for that when we only stop at period T? There’s a calculation, we’ll show you how to do that, and we’ll roll it into what we call a terminal value. There are some cash flows that could happen in the future beyond T, we’ll roll them up and account for them in period T. So we have to think about the terminal value and it’s only going to be in period capital T because we’re going to account for all of these future cash flows as a cash flow in period T of the terminal value.

So we’ve got our terminal value and we’ve got the account for the future. We’ve got all the cash flows discounted appropriately. What’s our what’s our investment decision? It comes down to figures of merit, calculations we make about the value of this investment, and then an acceptance criteria. We have to have a rule by which we will make our decision. A common one is called payback period. How long will it take for us to pay back the initial investments. That’s a fairly straightforward calculation. It’s important because it gives you a sense of how risky, how long it will take, because those future cash flows are not certain, but it doesn’t account for the time value of money. Two of the approaches that do account for time value of money are called net present value and internal rate of return. The calculation of net present value is taking our initial cash flow and then discounting all the cash flows up to period T, up to our final period here, discounting them as we said up here, and then calculating what is that net present value of all of those cash flows, including those upfront investments. Now the criteria for the net present value we want to have is that this should be greater than zero because our expectations is to get a return of the discount rate. So as long as our NPV is greater than zero, then it’s a good investment. Regarding payback period, it will be a criteria something like less than N periods, whatever N periods is, and that’s something that the firm will determine. Just like the firm will determine what is the rate we expect to get. Finally, the internal rate of return, that’s simply a calculation of the discount rate that gives you an NPV greater than zero. What’s the largest discount rate that gives you that? It gives you a sense of how robust the decision is. So it obviously needs to be greater than r, our expected rate of return or discount rate, but if it’s much greater than r, that means we’re pretty certain that we’re going to do a good job making this investment. So these are all the different principles. Again, I think it’s really critical that we, in supply chain, learn how to use the tools, like discounted cash flow analysis, that our colleagues in finance, the CFO and the CEO, use to make decisions. And in doing that, we will be communicating the real value of our supply chains throughout the organization. As always, use the practice problems and the short questions after the videos throughout, and practice using these tools of finance and, hopefully, you’ll be able to adopt them in your supply chain professional life.

Good luck.

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