FI3300
Corporation Finance – Chapter 11
Cash Flow & Capital Budgeting
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Learning Objectives

Find project cash flows

Describe the difference between independent
and mutually exclusive projects.

Compare projects with different lives using the
equivalent annual series technique.
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Estimating project cash flows 1
For this chapter, we focus on the NPV,
IRR and PI capital budgeting rules.
 To apply these rules, we need the
project’s cash flows and the appropriate
discount rate.
 In this chapter, you will learn how to
estimate a project’s cash flows. The
discount rate will still be given to you.

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Estimating project cash flows 2
 Guidelines:
Add back depreciation to net income.
 Ignore interest expense.
 All project cash flows must be
incremental.
 Ignore allocated costs and sunk costs.
 Include opportunity costs.
 Net working capital.

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Add back depreciation

Depreciation is a non-cash charge and
must be added to net income to estimate
cash flow.
Cash flow
= net income + depreciation expense
= (revenue – cost)x(1-tc) + (tc x depreciation)
tc: corporate tax rate
Note: Cost = all costs except depreciation
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Ignore interest expense
A project’s value (desirability) is
determined by the cash flows that
generates, not by how the project is
financed.
 In determining a project’s cash flows, we
ignore it’s financing cost, i.e., the interest
expense.

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All project cash flows
must be incremental

To evaluate a project, we look at the cash
flows which it contributes towards the firm’s
existing cash flows. In other words, we look at
project’s incremental cash flows.
How to determine incremental cash flows?
 Look at the firm’s cash flows without the
project.
 Look at the firm’s cash flows with the project.
 The difference is the incremental cash flows.
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Ignore allocated costs
and sunk costs

Allocated costs: rent, supervisory salaries,
administrative costs, and various overhead
expenses.
•

These costs are not incremental. They don’t
change even if the project is undertaken. Thus,
they should not be considered in estimating the
project’s incremental cash flows.
Sunk (irrecoverable) costs: costs which cannot
be recovered regardless of whether the firm
undertakes the project.
•
Examples: R&D expenses, consultant fees.
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Include opportunity costs

Suppose the project requires the use of some
asset owned by the firm.
 If the asset is not used by the project, the firm
can sell the asset for $X. This $X is the
opportunity cost of the asset. Such a cost
should be included in the project’s cost.
 An asset’s opportunity cost is the money that
the firm can receive if the asset is put to the
next best use. The ‘next best’ use may be to
sell the asset.
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Net working capital 1
Very often, a project will require an initial
increase in net working capital. This
increase in net working capital must be
added to the project’s costs.
 Assume that this additional working
capital is liquidated (sold for cash) at the
end of the project’s life.
 This liquidation is a cash inflow in the
last period.

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Net working capital 2
The opposite pattern is also possible.
 In other words, if taking on a project
REDUCES the net working capital, then
the size of this reduction is subtracted
from

•
•
the project’s initial cost.
the last period cash inflow.
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Capital budgeting example
 Problem
11.6
 You are given the responsibility of
conducting the project selection analysis
in your firm. You have to calculate the
NPV of a given project. The appropriate
cost of capital is 12 percent and the firm
is in the 30 percent tax bracket. You are
provided the following pieces of
information regarding the project:
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Details

The project is going to be built on a piece of
land that the firm already owns. The market
value of the land is $1 million.
 If the project is undertaken, prior to
construction, an amount of $100,000 would
have to be spent to make the land usable for
construction purposes.
 In order to come up with the project concept,
the company had hired a marketing research
firm for $200,000.
 The firm has spent another $250,000 on R&D
for this project.
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Details

The project will require an initial outlay of $20
million for plant and machinery.
 The sales from this project will be $15 million
per year of which 20 percent will be from lost
sales of existing products.
 The variable costs of manufacturing for this
level of sales will be $9 million per year.
 The company uses straight-line depreciation.
The project has an economic life of ten years
and will have a salvage value of $3 million at
the end.
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Details

Because of the project the company will need
additional working capital of $1 million which
can be liquidated at the end of ten years.
 The project will require additional supervisory
and managerial manpower that will cost
$200,000 per year.
 The accounting department has allocated
$350,000 as allocated overhead cost for
supervisory and managerial salaries.
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Calculate initial cost
 Initial
•
•
•
•
cost is the sum of:
Market value of land: $1 mil (opportunity cost)
Land improvement $100 k
Plant & machinery: $20 mil
Incremental working capital: $1 mil
Initial cost
= 1,000,000 + 100,000 + 20,000,000 + 1,000,000
= $22,100,000
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Calculate the annual incremental
cash flow: step 1
Calculate
the annual depreciation expense
For this project, fixed assets refer to $20mil plant &
machinery. Therefore,
Depreciation
= (20,000,000 – 3,000,000)/10
= $1,700,000
Calculate
incremental sales
Incremental sales = 0.8 x 15,000,000 = $12,000,000
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Calculate the annual incremental
cash flow: step 2
Draw up the incremental income statement
Incremental sales
12,000,000
Less Incremental variable cost
9,000,000
Less Incremental managerial salaries
200,000
Less Incremental depreciation
Equals Incremental taxable income
Less Incremental tax @30%
Equals Incremental net income
Add back depreciation
Incremental cash flow
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1,700,000
1,100,000
330,000
770,000
1,700,000
$2,470,000
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Consider other cash flows

At the end of project’s life (t=10), company
• Recovers $1 mil additional working capital
(item 9)
• Receives $3 mil salvage value from plant &
machinery (item 8)
Additional cash flows at end of project
= 1,000,000 + 3,000,000
= $4,000,000
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Let’s bring all the
cash flows together 1

CF0 (initial cost) = $22,100,000

Annual incremental after-tax cash flow (Year 1
through Year 10) = $2,470,000

Additional cash flow in Year 10 = $4,000,000
 So in year 10, the company receives a total of
= 2,470,000 + 4,000,000 = $6,470,000
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Let’s bring all the
cash flows together 2
To compute NPV, enter cash flows in this way:
CF0 = -22,100,000
C01 = 2,470,000, F01=9
C02 = 6,470,000, F02=1
Then press NPV, enter I = 12, press CPT and NPV.
NPV = -$6,856,056.17
Decision: reject the project.
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Mutually Exclusive Projects

Projects are mutually exclusive if accepting
one implies that the other projects will be
foregone.
 When projects are mutually exclusive and
have equal lives, you have to



rank the projects based on their NPVs
choose the best project, provided the project’s NPV
is positive
With mutually exclusive projects, choosing
the project with the highest NPV is always
correct.
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Question

Consider the following mutually exclusive
projects, for a firm using a discount rate of 10%:
Project NPV
IRR
PI
A
$100,000 10.2% 1.04
B
C
D
$1
$70,000
$24,000
11%
23%
13%
1.11
1.32
1.44
Which project(s) should the firm accept and why?
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Comparing projects with unequal lives:
Equivalent annual series (EAS)

When projects are mutually exclusive but have
unequal lives



We construct the equivalent annual series (EAS) of
each project and
We choose the project with the highest EAS
A project’s EAS is the payment on an annuity
whose life is the same as that of the project
and whose present value, using the discount
rate of the project, is equal to the project’s
NPV.
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Calculating EAS

Consider Projects J & K, with the following
cash flows. The discount rate is 10%.
Project
C0
C1
C2
C3
J
-12000
6000
6000
6000
K
-18000
7000
7000
7000
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C4
7000
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EAS for Project J
To compute Project J’s EAS, do the following:
 Compute Project J’s NPV

•
Verify that NPV(J) = $2,921.11

Find the payment on the 3-year (life of project J)
annuity whose PV is equal to $2,921.11.
Enter the following values:
N=3, I/Y=10, PV=-2921.11, FV=0, Then CPT, PMT.
PMT = 1,174.62, which is Project J’s EAS.
So, finding EAS is nothing more than finding the payment of
an annuity.
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EAS for Project K
Verify that Project K’s NPV= $4,189.06
 Find the payment on the 4-year (life of project K)
annuity whose PV is equal to $ 4,189.06.
Enter the following values:
N=4, I/Y=10, PV=- 4,189.06, FV=0, Then CPT, PMT.
PMT = 1,321.53, which is Project K’s EAS.
Recall that Project J’s EAS=1174.62
So, choose Project K since it has the higher EAS.

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Another application of EAS
 We
can use the EAS concept to choose
between two machines that do the same
job but have different costs and lives.
 Consider the following problem.
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Problem 11.9

Suppose that your firm is trying to decide
between two machines, that will do the same
job. Machine A costs $90,000, will last for ten
years and will require operating costs of
$5,000 per year. At the end of ten years it will
be scrapped for $10,000. Machine B costs
$60,000, will last for seven years and will
require operating costs of $6,000 per year. At
the end of seven years it will be scrapped for
$5,000. Which is a better machine? (discount
rate is 10 percent)
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Step 1: compute the PV of the costs of
each machine
PV of costs (A)
= $90,000 + PV of $5,000 annuity for ten years
- PV of the scrap (at t = 10) value of $10,000
= 90000 + 30722.84 – 3855.43 = $116,867.41
PV of costs (B)
= $60,000 + PV of $6,000 annuity for seven years
- PV of the scrap (at t = 7) value of $5,000
= $60,000 + $29,210.51 - $2,565.79 =$86,644.72
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Step 2: compute equivalent annual cost
(EAC) series of each machine

The equivalent annual cost series is the payment of
an annuity that has the same present value as the PV
of the machine’s cost.
EAC of machine A, EAC(A):
 N = 10, I/Y = 10, PV = -116867.41, FV = 0. Then
CPT, PMT. This yields EAC(A) = $19,019.63.
EAC of machine B, EAC(B):
 N = 7, I/Y = 10, PV = -86644.72, FV = 0. Then CPT,
PMT. This yields EAC(B) = $17,797.30.
 Choose machine B because it has the lower cost.
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Summary
Estimating a project’s after-tax
incremental cash flows.
 Choosing between mutually exclusive
projects.
 Comparing projects with unequal lives
using the EAS technique.

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Another problem
(Based on Spring 2001 Final Exam)
 ABC
Corp. manufactures television sets
and computer monitors. The company is
considering introducing a new 40” flat
screen television/monitor. The
company’s CFO has collected the
following information about the proposed
product.
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Details
1) The project has an anticipated economic life
of 5 years.
2) The company will have to purchase a new
machine to produce the screens. The
machine has an up front cost (t = 0) of
$4,000,000. The machine will be depreciated
on a straight-line basis over 5 years. The
company anticipates that the machine will
last for five years and then have no salvage
value (that is, it will be worthless).
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Details
3) If the company goes ahead with the proposed
product, it will have to increase inventory by
$280,000 and accounts payable by $80,0000.
At t = 5, the net working capital will be
recovered after the project is completed.
4) The screen is expected to generate sales
revenue of $2,000,000 the first year;
$4,500,000 the second through fourth years
and $3,000,000 in the fifth year. Each year the
operating costs (excluding depreciation) are
expected to equal 50% of sales revenue.
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Details
5) The company’s interest expense each year
will be $350,000.
6) The new screens are expected to reduce the
sales of the company’s large screen TV’s by
$500,000 per year.
7) The company’s cost of capital is 12%.
8) The company’s tax rate is 30%.
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Questions
What is the initial investment for the
project?
 What is the 3rd year expected
incremental operating cash flow? (i.e.,
the incremental after tax cash flow)
 What is the 5th year incremental nonoperating cash flow?

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Q1: initial investment
To answer Q1, you need points 2 & 3.
Initial investment

= machine cost + change in net working capital
= 4,000,000 + (change in current assets
– change in current liabilities)
= 4,000,000 + (280,000 – 80,000)
= $4,200,000
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Q2: 3rd incremental operating cash flow
To answer Q2, you need points 2,4,6,8.
Steps:
1) Incremental sales
= 4,500,000 – 500,000 = 4,000,000
2) Annual depreciation = (4,000,000)/5 =
800,000
3) Incremental operating cost for 3rd year
= 0.5 x 4,500,000 = 2,250,000
Next, draw up the incremental income statement
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Q2: 3rd incremental operating cash flow
Draw up the incremental income statement
Incremental sales
Less Incremental operating cost
Less Incremental depreciation
Equals Incremental taxable income
Less Incremental tax @30%
Equals Incremental net income
Add back depreciation
Incremental cash flow
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4,000,000
2,250,000
800,000
950,000
285,000
665,000
800,000
$1,465,000
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Q3: 5th year incremental
non-operating cash flow
Very simple. The only incremental nonoperating cash flow is the cash flow from
liquidating the increase in net working
capital (point 3).
 5th incremental
non-operating cash flow = $200,000

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