Chapter 7

Capital budgeting:
Cash Flows Estimation
To Thi Thanh Truc
Faculty of Finance and Banking
University of Economics and Law

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 Learning outcomes
After finishing this chapter you should be able to:
 Identify “relevant” cash flows that should and

should not be included in a capital budgeting

analysis.
 Estimate a project’s relevant cash flows and put

them into a time line format that can be used

to calculate a project’s NPV, IRR, and other
capital budgeting criteria.

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 Project’s Cash Flow
0 1 2 3 ... n

Initial OCF1 OCF2 OCF3 OCF4

Costs +
∆NWC1 ∆NWC2 ∆NWC3 Terminal
... ... ... CFs
NCF0 NCF1 NCF2 NCF3 NCF4

Initial Costs = Investment in Fixed Asset +

Initial Net Working Capital
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 Determining project value
 Estimate relevant cash flows
 Calculating annual operating cash flows.
 Identifying changes in working capital.
 Calculating terminal cash flows.
0 1 2 3 4

Initial OCF1 OCF2 OCF3 OCF4

Costs +
Terminal
CFs
NCF0 NCF1 NCF2 NCF3 NCF4
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Proposed Project
 Total depreciable cost
 Equipment: $200,000
 Shipping: $10,000
 Installation: $30,000
 Changes in working capital
 Inventories will rise by $25,000
 Accounts payable will rise by $5,000
 Effect on operations
 New sales: 100,000 units/year @ $2/unit
 Variable cost: 60% of sales
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Proposed Project
 Life of the project
 Economic life: 4 years
 Depreciable life: MACRS 3-year class
 Salvage value: $25,000
 Tax rate: 40%
 WACC: 10%

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 Determining project value
 Estimate relevant cash flows
 Calculating annual operating cash flows.
 Identifying changes in working capital.
 Calculating terminal cash flows.
0 1 2 3 4

Initial OCF1 OCF2 OCF3 OCF4

Costs +
Terminal
CFs
NCF0 NCF1 NCF2 NCF3 NCF4
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 Initial year net cash flow
 Find Δ NWC.
 in inventories of $25,000
 Funded partly by an in A/P of $5,000
 Δ NOWC = $25,000 - $5,000 = $20,000
 Combine Δ NOWC with initial costs.

Equipment -$200,000
Installation -40,000
Δ NWC -20,000
Net CF0 -$260,000
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Determining annual
depreciation expense
Year Rate x Basis Depr
1 0.33 x $240 $ 79
2 0.45 x 240 108
3 0.15 x 240 36
4 0.07 x 240 17
1.00 $240

Due to the MACRS ½-year convention, a

3-year asset is depreciated over 4 years.

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 Annual operating cash flows
1 2 3 4
Revenues 200.0 200.0 200.0 200.0
- Op Costs -120.0 -120.0 -120.0 -120.0
- Depr’n Expense -79.2 -108.0 -36.0 -16.8
Operating Income (BT) 0.8 -28.0 44.0 63.2
- Tax (40%) 0.3 -11.2 17.6 25.3
Operating Income (AT) 0.5 -16.8 26.4 37.9
+ Depr’n Expense 79.2 108.0 36.0 16.8
Operating CF 79.7 91.2 62.4 54.7
(Thousands of dollars)
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Terminal net cash flow
Recovery of NOWC $20,000
Salvage value 25,000
Tax on SV (40%) -10,000
Terminal CF $35,000

Q. How is NOWC recovered?

Q. Is there always a tax on SV?
Q. Is the tax on SV ever a positive cash
flow?
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 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)

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Proposed project’s cash flow time line
0 1 2 3 4

-260 79.7 91.2 62.4 54.7

Terminal CF → 35.0
89.7
 Enter CFs into calculator CFLO register, and enter I/YR = 10%.
 NPV = -$4.03 million
 IRR = 9.3%
 MIRR = 9.6%
 Payback = 3.3 years

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 More on NWC
 Why do we have to consider changes in NWC separately?
 Accounting Standards requires that sales be recorded

on the income statement when made, not when cash

is received
 Accounting Standards 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

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Depreciation
 The depreciation expense used for capital budgeting
should be the depreciation schedule tax purposes
 Depreciation itself is a non-cash expense;
consequently, it is only relevant because it affects
taxes
 Depreciation tax shield = DT
 D = depreciation expense

 T = marginal tax rate

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Computing Depreciation
 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

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 Pro Forma Statements and
Cash Flow
 Capital budgeting relies heavily on pro forma
accounting statements, particularly income
statements
 Computing cash flows – refresher
 Operating Cash Flow (OCF) = EBIT(1- T) +
depreciation
 Free cash flows (FCF) = OCF – Capital
expenditure – changes in NWC

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Should financing effects be
included in cash flows?
 No, dividends and interest expense
should not be included in the
analysis.
 Financing effects have already been
taken into account by discounting
cash flows at the WACC of 10%.
 Deducting interest expense and
dividends would be “double
counting” financing costs.
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Should a $50,000 improvement cost
from the previous year be included
in the analysis?
 No, the building improvement cost
is a sunk cost and should not be
considered.
 This analysis should only include
incremental investment.

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 If the facility could be leased out for
$25,000 per year, would this affect
the analysis?
 Yes, by accepting the project, the firm
foregoes a possible annual cash flow of
$25,000, which is an opportunity cost to be
charged to the project.
 The relevant cash flow is the annual after-
tax opportunity cost.
 A-T opportunity cost = $25,000 (1 – T)
= $25,000(0.6)
= $15,000

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If the new product line decreases
the sales of the firm’s other lines,
would this affect the analysis?
 Yes. The effect on other projects’
CFs is an “externality.”
 Net CF loss per year on other lines
would be a cost to this project.
 Externalities can be positive (in the
case of complements) or negative
(substitutes).

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If this were a replacement rather than a
new project, would the analysis change?
 Yes, the old equipment would be sold, and
new equipment purchased.
 The incremental CFs would be the changes
from the old to the new situation.
 The relevant depreciation expense would be
the change with the new equipment.
 If the old machine was sold, the firm would
not receive the SV at the end of the
machine’s life. This is the opportunity cost
for the replacement project.
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 Example: Replacement
Problem
 Original Machine  New Machine
 Initial cost = 100,000  Initial cost = 150,000
 Annual depreciation =  5-year life
9000  Salvage in 5 years = 0
 Purchased 5 years ago  Cost savings = 50,000
 Book Value = 55,000 per year
 Salvage today = 65,000  3-year MACRS
depreciation (33%, 45%,
 Salvage in 5 years =
15%, 7%)
10,000
 Required return =
10%
 Tax rate = 40% 7-23
 Replacement Problem –
Computing Cash Flows

 Remember that we are interested in

incremental cash flows
 If we buy the new machine, then we will
sell the old machine
 What are the cash flow consequences of
selling the old machine today instead of
in 5 years?

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 Replacement Problem – Pro Forma
Income Statements
Year 1 2 3 4 5

Cost 50,000 50,000 50,000 50,000 50,000

Savings
Depr.

New 49,500 67,500 22,500 10,500 0

Old 9,000 9,000 9,000 9,000 9,000

Increm. 40,500 58,500 13,500 1,500 (9,000)

EBIT 9,500 (8,500) 36,500 48,500 59,000

Taxes 3,800 (3,400) 14,600 19,400 23,600

NOPAT 5,700 (5,100) 21,900 29,100 35,400
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 Replacement Problem – FCF

Year 0 1 2 3 4 5

OCF 46,200 53,400 35,400 30,600 26,400

Capex -89,000 -10,000

 NOWC 0 0

FCF -89,000 46,200 53,400 35,400 30,600 16,400

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 Replacement Problem –
Incremental Net Capital Spending
 Year 0
 Cost of new machine = 150,000 (outflow)

 After-tax salvage on old machine = 65,000 -

.4(65,000 – 55,000) = 61,000 (inflow)
 Incremental net capital spending = 150,000 –
61,000 = 89,000 (outflow)
 Year 5
 After-tax salvage on old machine = 10,000 -
.4(10,000 – 10,000) = 10,000 (outflow
because we no longer receive this)

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 Replacement Problem – Analyzing
the Cash Flows

 Now that we have the cash flows, we

can compute the NPV and IRR
 Enter the cash flows
 Compute NPV = 54,812.10
 Compute IRR = 36.28%
 Should the company replace the
equipment?
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 Example: Cost Cutting
 Your company is considering a new computer
system that will initially cost $1 million. It will save
$300,000 a year in inventory and receivables
management costs. The system is expected to last
for five years and will be depreciated using 3-year
MACRS. The system is expected to have a salvage
value of $50,000 at the end of year 5. There is no
impact on net working capital. The marginal tax rate
is 40%. The required return is 8%.
 Click on the Excel icon to work through the example
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Relevant Cash Flows

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 Relevant Cash Flows

 The cash flows that should be included in a

capital budgeting analysis are those that will
only 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

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 Asking the Right Question

 You should always ask yourself “Will this cash flow

occur ONLY if we accept the project?”
 If the answer is “yes”, it should be included in

the analysis because it is incremental

 If the answer is “no”, it should not be included

in the analysis because it will occur anyway

 If the answer is “part of it”, then we should

include the part that occurs because of the

project
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 Estimating After - Tax
Incremental Cash Flow
Basic characteristics of relevant
project flows
 Cash (not accounting income) flows
 Operating (not financing) flows
 After-tax flows
 Incremental flows

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Estimating After - Tax
Incremental Cash Flow
Principles that must be adhered to
in the estimation
 Ignore sunk costs
 Include opportunity costs
 Include project-driven changes in
working capital net of spontaneous
changes in current liabilities
 Include effects of inflation
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 Calculating the
Incremental Cash Flows
 Initial cash outflow -- the initial net cash
investment.
 Yearly Incremental net cash flow =
Incremental operating cash flows –
changes in NWC -- those net cash flows
occurring after the initial cash
investment.
 Terminal incremental net cash flows
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 Initial Cash Outflow
a) Cost of “new” assets
b) + Capitalized expenditures
c) + (-) Increased (decreased) NWC
d) - Net proceeds from sale of
“old” asset(s) if replacement
e) + (-) Taxes (savings) due to the sale
of “old” asset(s) if replacement
f) = Initial cash outflow
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 Yearly Incremental Operating
Cash Flows
a) Net incr. (decr.) in operating revenue
less (plus) any net incr. (decr.) in
operating expenses, excluding depr.
b) - (+) Net incr. (decr.) in tax depreciation
c) = Net change in income before taxes
d) - (+) Net incr. (decr.) in taxes
e) = Net change in income after taxes
f) + (-) Net incr. (decr.) in tax depr. charges
g) = Incremental operating cash flow for
period
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 Terminal-Year Incremental
Cash Flows

a) + (-) Salvage value (disposal/reclamation

costs) of any sold or disposed assets
b) - (+) Taxes (tax savings) due to asset sale
or disposal of “new” assets
c) + (-) Decreased (increased) level of “net”
working capital
d) = Terminal year incremental net cash flow

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