Chapter 10 Making Capital Investment Decisions Project Cash Flows A First Look to evaluate a proposed investment first step is to decide which cash flows are relevant a relevant cash flow for a project is a change in the firm s overall future cash flow that comes about as a direct consequence of the decision to take that project incremental cash flows difference between a firm s future cash flows with a project and those without a project the incremental cash flows for project valuation consist of any and all changes in the firm s future cash flows that are a direct consequence of taking the project stand alone principle assumption that evaluation of a project may be based on the project s incremental cash flows sunk cost cost that has already been incurred and cannot be removed therefore should not be considered in an investment decision opportunity cost most valuable alternative that is given up if a particular investment is undertaken erosion cash flows of a new project that come at the new expense of a firm s existing projects some of the financing will be in the form of amounts owed to suppliers accounts payable but the firm will have to supply the balance This balance represents the investment in net working capital in analyzing a proposed investment we will not include interest paid or dividends because we are interested in the cash flow generated by assets Pro Forma Financial Statements and Project Cash Flows we have not deducted any interest expense OCF EBIT depreciation taxes More about Project Cash Flow the first thing we need when we begin evaluating a proposed investment is a set of pro forma projected financial statements pro forma financial statements financial statements projecting future years operating to prepare these statements we will need estimates of quantities sales price costs initial investment cash flow from assets has 3 components OCF capital spending and changed in NWC Total Cash Flow OCF NWC capital spending Cash income is sales increase in accounts receivable Cash costs is costs increase in accounts payable Cash flow cash inflow cash outflow OCF NWC Depreciation has cash flow consequences because it influences the tax bill Every asset is assigned to a particular class fixed percentage Book value of an asset can differ substantially from its actual market value o Book value initial cost accumulated depreciation o After tax salvage salvage T salvage book value o An asset s class establishes its life for tax purposes o Once the life is determined the depreciation for each year is computed by multiplying the cost of the asset by a Taxes must be paid if the difference between market and book value is excess depreciation and must be recaptured when the asset is sold Capital gain occurs only if the market price exceeds the original cost If the book value exceeds the market value then the difference is treated as a loss for tax purposes Straight line depreciation initial cost salvage number of years Alternative Definitions of Operating Cash Flow CFFA OCF NCS NWC EBIT sales costs depreciation Taxes EBIT x corporate tax rate OCF EBIT depreciation taxes OCF NI depreciation bottom up approach if no interest OCF sales costs taxes top down approach OCF sales costs x 1 T depreciation