SKEMA BUSINESS SCHOOL

Lecture 4
Making capital investment decisions
Incremental cash flows
 Reading requirements

Chapter 7 Making capital investment decisions

Corporate Finance, European edition,
by Hillier, Ross, Westerfield, Jaffe and Jordan,
McGraw-Hill ed., 4th.
Get access to the book @ https://k2.skema.edu
in the course Corporate Finance

Lecture 4: Making investment captal decisions - Incremental cash flows 2

 Outlines

• The predominance of NPV and the importance of IRR

• The main lines of reasoning
• Which cash flows are important ?
• Other investment criteria

Lecture 4: Making investment captal decisions - Incremental cash flows 3

 The predominance of NPV and the importance
of IRR

NPV, return and risk are linked !!!!

The net present value (NPV) of an investment is the value of

the positive and negative cash flows arising from an
investment, discounted at the rate of return required by the
market. The rate of return is based upon the investment’s
risk.

The internal rate of return (IRR) is simply the rate of return on

an investment. Given an investment’s degree of risk, it is
financially worthwhile if the IRR is higher than the required
return.

Lecture 4: Making investment captal decisions - Incremental cash flows 4

 The main lines of reasoning

An investment decision must respect six principles :

1. Consider cash flows rather than accounting data

2. Think in terms of incremental cash flows
3. Think in terms of opportunity
4. Disregard the type of financing
5. Consider taxation
6. Be consistent

Lecture 4: Making investment captal decisions - Incremental cash flows 5

 The main lines of reasoning

Consider cash flows rather than accounting data

Accounting measures are irrelevant because they do not

take into account working capital and include
depreciation which is a noncash item.

Only cash flows are relevant in an investment decision.

Lecture 4: Making investment captal decisions - Incremental cash flows 6

 Reminder: The Working Capital Cycle

Let's imagine a very simple business: a company buys raw

materials for cash, processes them into finished goods
and then sells these goods on credit to its customers
How does it work?
Cash
Accounts receivable Raw materials inventory

Finished goods inventory

Lecture 4: Making investment captal decisions - Incremental cash flows 7

 Reminder: The Working Capital Cycle
Reminder: The Working Capital Cycle

(Net) working capital

• Financial resources (i.e. the capital) required to make work
the business
• N.W.C. = current assets less current liabilities

Current assets Current Liabilities

◆ Accounts receivable ◆ Short-term loans
◆ Inventory ◆ Accounts payable
◆ Accrued income taxes
◆ Current payment on
long-term debt

Lecture 4: Making investment captal decisions - Incremental cash flows 8

 Reminder: The Working Capital Cycle
Reminder: The Working Capital Cycle

(Net) working capital

• Financial Resources or Financial Surplus

Current Liabilities
◆ Short-term loans
◆ Accounts payable
Current assets ◆ Accrued income taxes
◆ Accounts receivable ◆ Current payment on
◆ Inventory long-term debt

Financial Resources
Required

Lecture 4: Making investment captal decisions - Incremental cash flows 9

 Reminder: The Working Capital Cycle
Reminder: The Working Capital Cycle

(Net) working capital

• Financial Resources or Financial Surplus

Current assets Current Liabilities

◆ Accounts receivable ◆ Short-term loans
◆ Inventory ◆ Accounts payable
◆ Accrued income taxes
Cash Surplus ◆ Current payment on
Generated long-term debt

Lecture 4: Making investment captal decisions - Incremental cash flows 10

 The main lines of reasoning

Think in terms of incremental cash flows

When considering an investment, one must take into account all

the flows it generates, and nothing else but these flows.

Only consider the future cash flows arising from the investment.
Our objective is to calculate the investment’s marginal
contribution to the company profitability.

Lecture 4: Making investment captal decisions - Incremental cash flows 11

 The main lines of reasoning

Think in terms of opportunity

The CFO must constantly be prepared to question each activity

and reason in terms of :
- Buying and selling assets
- Entering or withdrawing from an economic sector

The CFO is an “asset dealer”.

Lecture 4: Making investment captal decisions - Incremental cash flows 12

 The main lines of reasoning

Disregard the type of financing

Only operating and investment flows are taken into account,

but never financing flows. Failure to do so would disturb the
NPV, since the impact of financing would be included twice :
- First, within the required return; and
- Second, within the cash flows.

N
Second effect
NPV = å
Fn
n
-V0
n=1 (1+ r )
First effect

Lecture 4: Making investment captal decisions - Incremental cash flows 13

 The main lines of reasoning

Consider taxation

• CFO maximize their after-tax flows. So they must consider :

- tax savings generate by the depreciation and amortisation;
- tax impact on the cash flows generated by the investment;
- tax shields, tax credits, rebates, subsidies and other
advantages for carrying out investment projects.

Lecture 4: Making investment captal decisions - Incremental cash flows 14

 Which cash flows are important ?

Operating flows

In the income statement, we must :

- focus on operating income;
- consider the tax implications, and
- remember that depreciation is a noncash item

Lecture 4: Making investment captal decisions - Incremental cash flows 15

 Which cash flows are important ?

Operating flows

Operating flows formula :

Operating cash flow = EBIT(1-Tc) + D/A + change in NWC
EBIT is earnings before interests and taxes

Tc is corporate tax rate

D/A is depreciation and amortization

NWC is net working capital

Note that in some books, the change in NWC is not considered as an operating flow
but as an investment flow (see the next slide). But no matter where it is incorporated, it
must be taken into account either in the operating flow or in the investment flow.

Lecture 4: Making investment captal decisions - Incremental cash flows 16

 Which cash flows are important ?

Investment flows

• Investment in fixed assets includes :

- Tangible assets (building, land …)
- Intangible assets (research and development, patent …)
- Financial assets (shares in subsidiaries)

• But, there are also disvestment cash flows (usually positive

and taxed), when you decide to sell your assets.
• Include change in net working capital, if not already done in
the operating cash flow (previous slide)
• And keep in mind that changes in working capital are just a
matter of time lag => at the end of the project's life, the
working capital is recovered

Lecture 4: Making investment captal decisions - Incremental cash flows 17

 Which cash flows are important ?

Extraordinary flows

CFO knows that certain expenses have not been booked under
EBITDA (litigation, tax audits …etc.). These expenses must be
included on an after-tax basis in the calculation of estimated
cash flows.

Lecture 4: Making investment captal decisions - Incremental cash flows 18

 Example

• Ginza ltd
• Sales as of year 0 were €1,000,000 and net income
was €60,000
• Ginza considers an important investment project that
would improve its sales and increase its profitability. It
is considering an investment opportunity for which
accelerated depreciation is allowed over 5 years
(depreciation rate is 40%, 40%, 40%, 50%, 100% of the
remaining net asset value).

Lecture 4: Making investment captal decisions - Incremental cash flows 19

 Example

• Ginza ltd
• Investment opportunity
• Initial outlay €100,000
• Increase in sales (compared to year 0)
• Year 1 €100,000
• Year 2 €120,000
• Year 3 €140,000
• Year 4 €160,000
• Year 5 €180,000
• Salvage value €10,000

Lecture 4: Making investment captal decisions - Incremental cash flows 20

 Example

• Ginza ltd
• We know that the contribution margin makes 30% of
sales before tax and the net working capital is about 72
days of annual sales before tax.
• Based on NPV, IRR and Payback Period do you think the
company should invest in this project?
• The corporate tax rate is 45% and the discount rate is
10%.

Lecture 4: Making investment captal decisions - Incremental cash flows 21

 Example

• Ginza ltd
• We shall assume that
• The invesment is made at the very beginning of the first
year
• Cash flows are available end-of-year
• The net working capital must be financed at the
beginning of the year
• The equipment is resold for its salvage value at the end
of the 5th year, a tax of 45% on capital gains being
recorded

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 Example correction

1. Estimate free cash flows on an incremental basis

2. Include all incidental effects

3. Do not forget working capital requirements

Lecture 4: Making investment captal decisions - Incremental cash flows 23

 Example correction

• Estimate free cash flows

• Compute the net income in order to estimate the
taxes to be paid (on an incremental basis)
• Estimate the FCF

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 Example correction

Lecture 4: Making investment captal decisions - Incremental cash flows 25

 Example correction

• In the Ginza example, since there is no debt, there is

no interest payment and then EBIT(1-Tc) = Net result.
• Therefore, we can calculate the operating cash flow
from the net result
• But if there were interest payments, we should use
EBIT(1-Tc) as shown in slide 16

Lecture 4: Making investment captal decisions - Incremental cash flows 26

 Example correction

• NPV

Discount rate 10,00%

Year 0 1 2 3 4 5
FCF (120 000) 30 500 26 600 25 580 27 260 76 060
DCF (120 000) 27 727 21 983 19 219 18 619 47 227
NPV 14 776

Lecture 4: Making investment captal decisions - Incremental cash flows 27

 Example correction

• Internal rate of return

Discount rate 14,04%

Year 0 1 2 3 4 5
FCF (120 000) 30 500 26 600 25 580 27 260 76 060
DCF (120 000) 26 745 20 454 17 248 16 118 39 435
NPV 0

Lecture 4: Making investment captal decisions - Incremental cash flows 28

 Example correction

• Payback Period
• Project A
Payback
Free Cash
Year Payback
Flows 100 000

0 (120 000) (120 000) 50 000

1 30 500 (89 500)
0
2 26 600 (62 900)
3 25 580 (37 320) (50 000)

4 27 260 (10 060) (100 000)

5 76 060 66 000
(150 000)
0 1 2 3 4 5

• Payback period = 4 years 1 month and 18 days

Lecture 4: Making investment captal decisions - Incremental cash flows 29

 Example correction

• Discounted Payback Period

• Project A
Discounted Payback

Discounted Discounted 40 000

Year 20 000
Cash Flows Payback 0
0 (120 000) (120 000) (20 000)

1 27 727 (92 273) (40 000)

(60 000)
2 21 983 (70 289) (80 000)
3 19 219 (51 071) (100 000)
(120 000)
4 18 619 (32 452)
(140 000)
5 47 227 14 776 0 1 2 3 4 5

• Payback period = 4 years 8 months and 7 days

Lecture 4: Making investment captal decisions - Incremental cash flows 30