project cash flow – incremental cash flow (ch. 10.4 – 10.7) 05/22/06

Project Cash Flow – Project Cash Flow – Incremental Cash Flow (Ch. Incremental Cash Flow (Ch.

10.4 – 10.7)10.4 – 10.7)

05/22/0605/22/06

Relevant cash flowsRelevant cash flows

• The relevant cash flows to evaluate a The relevant cash flows to evaluate a project are the project are the incremental cash flows incremental cash flows that the project generates for the firm. that the project generates for the firm.

• Incremental cash flows can be defined as Incremental cash flows can be defined as the change in the firm’s future cash flows the change in the firm’s future cash flows that are a direct consequence of that are a direct consequence of accepting accepting the project.the project.

Relevant cash flowsRelevant cash flows• Cash outlays already made (Cash outlays already made (sunk costssunk costs) are ) are

irrelevantirrelevant to the decision process as they to the decision process as they will be incurred regardless of project will be incurred regardless of project acceptance or rejection.acceptance or rejection.– For example, marketing costs used to determine For example, marketing costs used to determine

consumer interest in the product generated by the consumer interest in the product generated by the new project are sunk.new project are sunk.


• Erosion costs (or costs from Erosion costs (or costs from cannibalization)cannibalization), are cash flows (from sales) , are cash flows (from sales) that are lost from other products produced that are lost from other products produced by the firm as a direct consequence of by the firm as a direct consequence of accepting the project. These cash flows accepting the project. These cash flows are are relevant relevant in evaluating the project. in evaluating the project.


• A related, but broader set of costs are the A related, but broader set of costs are the opportunity costsopportunity costs, which are cash flows , which are cash flows that could be realized from the best that could be realized from the best alternative use of the asset(s) that the alternative use of the asset(s) that the project will use. These project will use. These are relevantare relevant cash cash flows in evaluating the project.flows in evaluating the project.– For example, if the new project is located in a For example, if the new project is located in a

previously used facility, the firm does not incur costs previously used facility, the firm does not incur costs to purchase the facility but could have sold the to purchase the facility but could have sold the facility. This sales price would represent an facility. This sales price would represent an opportunity cost.opportunity cost.

• Categories of cash flows:Categories of cash flows:– Initial cash flowsInitial cash flows are cash flows resulting initially are cash flows resulting initially

from the project. from the project. • Initial investment and working capital investmentInitial investment and working capital investment

– Operating cash flowsOperating cash flows are the cash flows are the cash flows generated by the project during its operation. generated by the project during its operation. These are determined by the revenues and These are determined by the revenues and expenses the project generates for the firm.expenses the project generates for the firm.

– Terminal cash flowsTerminal cash flows result from the disposition of result from the disposition of the project’s assetsthe project’s assets• Salvage value and working capital recoupSalvage value and working capital recoup


• Initial capital investmentInitial capital investment– Purchase price of new asset.Purchase price of new asset.– Installation costs necessary to place asset into operation.Installation costs necessary to place asset into operation.

• Working capital investmentWorking capital investment– Net working capital = current assets – current liabilities.Net working capital = current assets – current liabilities.– New asset acquisitions usually result in increased levels of New asset acquisitions usually result in increased levels of

working capital (inventory, accounts receivable and working capital (inventory, accounts receivable and accounts payable) to support expanded operations.accounts payable) to support expanded operations.

– This increase in working capital (i.e., This increase in working capital (i.e., change in net change in net working capital) working capital) is treated as a initial cash outflow.is treated as a initial cash outflow.

Initial cash flowsInitial cash flows

Operating cash flowsOperating cash flows

• Operating cash flows (OCFs) associated with a project Operating cash flows (OCFs) associated with a project can be derived from accounting earnings of the can be derived from accounting earnings of the project and represent cash flows the project is project and represent cash flows the project is expected to generate. expected to generate.

• The major difference between accounting earnings The major difference between accounting earnings and cash flows is due to depreciation.and cash flows is due to depreciation.

• Depreciation is a non-cash expense, however, it has Depreciation is a non-cash expense, however, it has cash flow consequences because it influences the cash flow consequences because it influences the firm’s tax payment.firm’s tax payment.

• DepreciationDepreciation– Depreciation for tax purposes is determined by using the Depreciation for tax purposes is determined by using the

modified accelerated cost recovery system (MACRS)modified accelerated cost recovery system (MACRS) ..

– Under the basic MACRS procedures, the depreciable value of an Under the basic MACRS procedures, the depreciable value of an asset is its full cost, including outlays for installation.asset is its full cost, including outlays for installation.

– No adjustment is required for expected salvage value, i.e., the No adjustment is required for expected salvage value, i.e., the asset is depreciated to zero.asset is depreciated to zero.

– For tax purposes, the depreciable life of an asset is determined For tax purposes, the depreciable life of an asset is determined by its MACRS recovery predetermined period and is based on the by its MACRS recovery predetermined period and is based on the type of asset.type of asset.



YearYear 3-year3-year 5-year5-year 7-year7-year 10-year10-year

11 33.3333.33 20.0020.00 14.2914.29 10.0010.00

22 44.4544.45 32.0032.00 24.4924.49 18.0018.00

33 14.8114.81 19.2019.20 17.4917.49 14.4014.40

44 7.417.41 11.5211.52 12.4912.49 11.5211.52

55 11.5211.52 8.938.93 9.229.22

66 5.765.76 8.938.93 7.377.37

77 8.938.93 6.556.55

88 4.454.45 6.556.55

99 6.566.56

1010 6.556.55

1111 3.283.28

MACRS fixed annual expense percentages by recovery period

• Operating cash flows (OCF) are calculated as follows:Operating cash flows (OCF) are calculated as follows:– Earnings before Income and Taxes (EBIT) for the project are determined, which Earnings before Income and Taxes (EBIT) for the project are determined, which

typically are revenues less all relevant operating expenses including depreciation.typically are revenues less all relevant operating expenses including depreciation.

– Taxes are calculated on these earnings.Taxes are calculated on these earnings.– Depreciation is added back to these operating earnings because it is a non-cash Depreciation is added back to these operating earnings because it is a non-cash

expense.expense.


Project OCF = Project EBIT – Taxes + Depreciation

• After-tax sale of capital assetAfter-tax sale of capital asset– When a depreciable asset is sold, a gain or loss When a depreciable asset is sold, a gain or loss

on disposal is calculated based on the book on disposal is calculated based on the book value of the asset at the time of disposal. value of the asset at the time of disposal. Taxes are based on this gain or loss.Taxes are based on this gain or loss.

Cash flow from asset sale:Cash flow from asset sale:

Sale price – (Sale price – Book value) * tax rateSale price – (Sale price – Book value) * tax rate

Terminal cash flowsTerminal cash flows

• Working capital recoupWorking capital recoup– Reduction in net working capital requirements Reduction in net working capital requirements

after the project is terminated.after the project is terminated.– Typically this is just the original working capital Typically this is just the original working capital

investment.investment.

Terminal cash flowsTerminal cash flows

Relevant cash flows for Relevant cash flows for replacement projectsreplacement projects

• Estimating incremental cash flows is Estimating incremental cash flows is relatively straightforward in the case of relatively straightforward in the case of expansion projectsexpansion projects, but not so in the case , but not so in the case of of replacement projectsreplacement projects..

• With replacement projects, incremental With replacement projects, incremental cash flows must be computed by cash flows must be computed by subtracting existing project cash flows subtracting existing project cash flows from those expected from the new project.from those expected from the new project.

project cash flow – incremental cash flow (ch. 10.4 – 10.7) 05/22/06

Documents