• The purpose of a project may be to:

– Grow the firm causing future sales, profits, and cash flows to
increase; includes typical expansion projects.

– Reduce the firm’s future operating costs causing future

profits and cash flows to increase; examples include new,
more efficient air conditioners or new kitchen equipment
requiring less maintenance.

– Meet legal requirements or satisfy ethical considerations;

examples include fire alarm and fire suppression systems.
 Project Cash Flows
• Estimating a project’s impact on a firm’s future
cash flows is a crucial part of the investment
decision. Some basic principles need to be
followed when estimating a project’s cash
flows:

– An incremental basis
– An after-tax basis
– Indirect effects should be included
– Costs should be measured as opportunity costs and not based
upon historical or sunk costs
 Project Cash Flows
• The capital budgeting decision is essentially
based upon a cost/benefit analysis.

– The cost of a project is called the net

investment.

– The benefits from a project are the future

cash flows generated. We call these the net
cash flows.
 Net Investment
• The net cash outflows required to ready a
project for its basic operation; the net
investment includes:

– Cost of any assets

– + Delivery costs
– + Installation costs
– + Any required increase in net working capital
– – After-tax salvage value from replaced assets
 Net Cash Flows
• These are the future cash flows generated
from a project once it commences operation.
The net cash flows are expected to continue
throughout the project’s economic life.

• The net cash flow for each year is:

–  Earnings before taxes x (1 – t)
– +  Depreciation
– -  Net working capital
 Net Cash Flows
• And  Earnings before taxes is estimated by:

–  Sales revenue
– –  Operating expenses
– –  Depreciation

• Interest expense is generally not included in the net cash

flows since it will be taken into account later through the
firm’s required rate of return.
 Terminal Nonoperating Cash Flow
• These are special one-time cash flows that
only occur at the end of a project’s life. They
are added to a project’s last net cash flow.
They include:

– After-tax salvage value of the project’s assets

– Return of any increased net working capital

 Computation of After-Tax Salvage Values

• Taxes owed on salvage value depend upon the

salvage price relative to the asset’s book value.

• As asset’s book value is the asset’s original

acquisition cost minus all depreciation taken on the
asset (accumulated depreciation).
 Computation of After-Tax Salvage Values
• If an asset is sold for its book value then no
taxes are owed.

• If an asset is sold for more than book value,

then taxes are owed on this excess.

• If an asset is sold for less than book value, then

taxes are reduced. The loss acts as a tax
shelter, reducing taxes by an amount equal to
the firm’s marginal tax rate times the deficit.
 Depreciation
• The depreciation actually affecting cash flow is
MACRS depreciation used for taxes.

• MACRS depreciation varies by type of asset

but always depreciates to a zero value, not an
estimated salvage value.

• Here we will simplify by assuming straight-line

depreciation to a zero value.
 Depreciation
• Depreciation shelters income from taxes.

• Thus, greater depreciation reduces taxes.

• Depreciation is not an out-of-pocket expense.

• Thus an increase in depreciation will reduce

profit but increase cash flow.