1. Project Cash Flow – Incremental Cash Flow (Ch. 10.4 – 10.7) 05/22/06

2. Relevant cash flows Relevant cash flows The relevant cash flows to evaluate a project are the incremental cash flows that the project generates for the firm. The relevant cash flows to evaluate a project are the incremental cash flows that the project generates for the firm. Incremental cash flows can be defined as the change in the firm’s future cash flows that are a direct consequence of accepting the project. Incremental cash flows can be defined as the change in the firm’s future cash flows that are a direct consequence of accepting the project.

3. Relevant cash flows Cash outlays already made (sunk costs) are irrelevant to the decision process as they will be incurred regardless of project acceptance or rejection. Cash outlays already made (sunk costs) are irrelevant to the decision process as they will be incurred regardless of project acceptance or rejection. –For example, marketing costs used to determine consumer interest in the product generated by the new project are sunk.

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

5. Relevant cash flows A related, but broader set of costs are the opportunity costs, which are cash flows that could be realized from the best alternative use of the asset(s) that the project will use. These are relevant cash flows in evaluating the project. A related, but broader set of costs are the opportunity costs, which are cash flows that could be realized from the best alternative use of the asset(s) that the project will use. These are relevant cash flows in evaluating the project. –For example, if the new project is located in a previously used facility, the firm does not incur costs to purchase the facility but could have sold the facility. This sales price would represent an opportunity cost.

6. Categories of cash flows: Categories of cash flows: –Initial cash flows are cash flows resulting initially from the project. Initial investment and working capital investment Initial investment and working capital investment –Operating cash flows are the cash flows generated by the project during its operation. These are determined by the revenues and expenses the project generates for the firm. –Terminal cash flows result from the disposition of the project’s assets Salvage value and working capital recoup Salvage value and working capital recoup Relevant cash flows

7. Initial capital investment Initial capital investment –Purchase price of new asset. –Installation costs necessary to place asset into operation. Working capital investment Working capital investment –Net working capital = current assets – current liabilities. –New asset acquisitions usually result in increased levels of working capital (inventory, accounts receivable and accounts payable) to support expanded operations. –This increase in working capital (i.e., change in net working capital) is treated as a initial cash outflow. Initial cash flows

8. Operating cash flows Operating cash flows (OCFs) associated with a project can be derived from accounting earnings of the project and represent cash flows the project is expected to generate. Operating cash flows (OCFs) associated with a project can be derived from accounting earnings of the project and represent cash flows the project is expected to generate. The major difference between accounting earnings and cash flows is due to depreciation. The major difference between accounting earnings and cash flows is due to depreciation. Depreciation is a non-cash expense, however, it has cash flow consequences because it influences the firm’s tax payment. Depreciation is a non-cash expense, however, it has cash flow consequences because it influences the firm’s tax payment.

9. Depreciation Depreciation –Depreciation for tax purposes is determined by using the modified accelerated cost recovery system (MACRS). –Under the basic MACRS procedures, the depreciable value of an asset is its full cost, including outlays for installation. –No adjustment is required for expected salvage value, i.e., the asset is depreciated to zero. –For tax purposes, the depreciable life of an asset is determined by its MACRS recovery predetermined period and is based on the type of asset. Operating cash flows

11. Year3-year5-year7-year10-year 133.3320.0014.2910.00 244.4532.0024.4918.00 314.8119.2017.4914.40 47.4111.5212.4911.52 511.528.939.22 65.768.937.37 78.936.55 84.456.55 96.56 106.55 113.28 MACRS fixed annual expense percentages by recovery period

12. 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 typically are revenues less all relevant operating expenses including depreciation. –Taxes are calculated on these earnings. –Depreciation is added back to these operating earnings because it is a non-cash expense. Operating cash flows Project OCF = Project EBIT – Taxes + Depreciation

13. After-tax sale of capital asset After-tax sale of capital asset –When a depreciable asset is sold, a gain or loss on disposal is calculated based on the book value of the asset at the time of disposal. Taxes are based on this gain or loss. Cash flow from asset sale: Sale price – (Sale price – Book value) * tax rate Terminal cash flows

14. Working capital recoup Working capital recoup –Reduction in net working capital requirements after the project is terminated. –Typically this is just the original working capital investment. Terminal cash flows

15. Relevant cash flows for replacement projects Estimating incremental cash flows is relatively straightforward in the case of expansion projects, but not so in the case of replacement projects. Estimating incremental cash flows is relatively straightforward in the case of expansion projects, but not so in the case of replacement projects. With replacement projects, incremental cash flows must be computed by subtracting existing project cash flows from those expected from the new project. With replacement projects, incremental cash flows must be computed by subtracting existing project cash flows from those expected from the new project.