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Making Capital Investment Decisions Relevant Cash Flow

This document discusses key concepts for making capital investment decisions, including: - Capital budgeting analysis should only consider incremental cash flows from a project. - Common types of cash flows are sunk costs, opportunity costs, side effects, changes in net working capital, financing costs, and taxes. - Pro forma statements, particularly income statements, are important to compute cash flows like operating cash flow and cash flow from assets. Depreciation affects taxes and is thus relevant to capital budgeting analysis despite being a non-cash expense.

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Mikhael Parmon
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31 views

Making Capital Investment Decisions Relevant Cash Flow

This document discusses key concepts for making capital investment decisions, including: - Capital budgeting analysis should only consider incremental cash flows from a project. - Common types of cash flows are sunk costs, opportunity costs, side effects, changes in net working capital, financing costs, and taxes. - Pro forma statements, particularly income statements, are important to compute cash flows like operating cash flow and cash flow from assets. Depreciation affects taxes and is thus relevant to capital budgeting analysis despite being a non-cash expense.

Uploaded by

Mikhael Parmon
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as DOCX, PDF, TXT or read online on Scribd
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CHAPTER 10

MAKING CAPITAL INVESTMENT DECISIONS

Relevant cash flow


The cash flows that should be included in a capital budgeting analysis are those that will only
occur (or not occur) if the project is accepted. These cash flows are called incremental cash
flows. The stand-alone principle allows us to analyze each project in isolation from the firm
simply by focusing on incremental cash flows.

Common types of cash flow


 Sunk costs – costs that have accrued in the past
 Opportunity costs – costs of lost options
 Side effects
- Positive side effects – benefits to other projects
- Negative side effects – costs to other projects
 Changes in net working capital
 Financing costs
 Taxes

Pro forma statement and cash flow


Capital budgeting relies heavily on pro forma accounting statements, particularly income
statements. Computing cash flows – refresher:
- Operating Cash Flow (OCF) = EBIT + depreciation taxes
- OCF = Net income + depreciation (when there is no interest expense)
- Cash Flow From Assets (CFFA) = OCF – net capital spending (NCS) – changes in NWC

Reasons of why we have to consider changes in net working capital (NWC)


 GAAP requires that sales be recorded on the income statement when made, not when
cash is received
 GAAP also requires that we record cost of goods sold when the corresponding sales are
made, whether we have actually paid our suppliers yet
 Finally, we have to buy inventory to support sales, although we haven’t collected cash yet

Depreciation
The depreciation expense used for capital budgeting should be the depreciation schedule required
by the IRS for tax purposes. Depreciation itself is a non-cash expense; consequently, it is only
relevant because it affects taxes.

Depreciation tax shield = D × T


 D = depreciation expense
 T = marginal tax rate

Straight-line depreciation
 D = (Initial cost – salvage) / number of years
 Very few assets are depreciated straight-line for tax purposes

MACRS
 Need to know which asset class is appropriate for tax purposes
 Multiply percentage given in table by the initial cost
 Depreciate to zero
 Mid-year convention

After tax salvage


If the salvage value is different from the book value of the asset, then there is a tax effect

Book value = initial cost – accumulated depreciation

After-tax salvage = salvage – T*(salvage – book value)

Others method of computing OCF


Bottom-Up Approach
 OCF = NI + depreciation
 Works only when there is no interest expense

Top-Down Approach
 OCF = Sales – Costs – Taxes
 Don’t subtract non-cash deductions

Tax Shield Approach


 OCF = (Sales – Costs)(1 – T) + Depreciation*T

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