Discounted Cash Flow Analysis and Royalty Rates

A variation of the investment rate-of-return analysis can also be used for royalty rate derivation. This alternate method makes use of a discounted cash flow analysis, which converts a stream of expected cash flow into a present value. The conversion is accomplished by using a discount rate, reflecting the risk of the expected cash flow. In addition to the benefits previously listed, from using an investment rate-of-return analysis, the discounted cash flow analysis also reflects the

• time period during which economic benefits will be obtained.
  
• timing and amount of capital expenditure investments.
  
• timing and amount of working capital investments.
  
• timing and amount of other investments in intellectual property and intangible assets not associated with the subject technology.

NET SALES minus

MANUFACTURING COSTS equals

GROSS PROFITS

GROSS PROFITS minus

MARKETING EXPENSES and

GENERAL OVERHEAD EXPENSES and

ADMINISTRATION EXPENSES and

SELLING EXPENSES equals

OPERATING PROFITS

OPERATING PROFITS minus

INCOME TAXES equals

NET INCOME

NET INCOME plus

DEPRECIATION equals

GROSS CASH FLOW

GROSS CASH FLOW minus

ADDITIONS TO WORKING CAPITAL and

ADDITIONS TO FIXED PLANT INVESTMENT equals

NET CASH FLOW

Sales represent the revenue dollars collected by the company from providing products or services to customers. Net sales is the amount of revenue that remains after discounts, returns, and refunds.

Manufacturing costs are the primary costs associated with making or providing the product or service. Included in this expense category are expenses associated with labor, raw materials, manufacturing plant costs, and all other expenses directly related to transforming raw materials into finished goods.

• research expenses associated with creating new products, and enhancing old ones.
  
• marketing expenses required for motivating customers to purchase the products or service.
  
• general overhead expenses required for providing basic corporate support for commercialization activities.
  
• selling expenses associated with salaries, commissions, and other activities, that keep product moving into the hands of customers.

Operating profits reflect the amount left over after non-manufacturing expenses are subtracted from gross profits.

Income taxes are expense of doing business, and must be accounted for in valuing any business initiative.

Depreciation expense is calculated based on the remaining useful life of equipment purchased for business purposes. It is a non-cash expense that allocates the original amount invested in fixed assets to annual operations. Depreciation is calculated to account for the deterioration of fixed assets, as they are used to produce, market, sell, deliver, and administer the process of generating sales. Depreciation accounts for the using-up of assets. It is called a “non-cash” expense, because the cash associated with the expense was disbursed long ago, at the time that fixed assets were purchased and installed. The depreciation expense is subtracted before reaching operating profit, so that income taxes will reflect depreciation as an expense of doing business.

Gross cash flow is calculated by adding the depreciation expense, previously subtracted to calculated operating income, back into the after-tax income of the business. Gross cash flow represents the total amount of cash that the business generates each year. Additions to working capital, and additions to fixed plant investment, are investments in the business required to fuel continued production capabilities. Net cash flow is everything that remains of gross cash flow, after accounting for reinvestment in the business for fixed plant and working capital additions.

GENERIC AND MATURE COMMODITY CORPORATE VALUE