CH 11

Fundamentals of Corporate
Finance
by
Robert Parrino, Ph.D. & David S. Kidwell, Ph.D.
Chapter 11 Cash Flows and Capital Budgeting
Copyright 2008 John Wiley & Sons
CHAPTER 11
Cash Flows and Capital
Budgeting
Quick Links
Calculating Project Cash Flows
Estimating Cash Flows in Practice
Important Concepts for Cash-Flow Calculations
Forecasting Cash Flows
Special Cases
Calculating Project Cash

Flows
The Importance of Capital Budgeting
In capital budgeting, we estimate the NPV of the
cash flows that a project is expected to produce in

the future.
All of the cash-flow estimates are forward looking.

Flows
Incremental Free Cash Flows
The cash flows we discount in an NPV analysis
are the incremental after-tax free cash flows

which refers to the fact that these cash flows
reflect the amount by which the firms total aftertax free cash flows will change if the project is
adopted. See the equation below.
FCFproject = FCFwith
project
FCF without project (11.1)

Flows
Incremental Free Cash Flows
The term free cash flows refers to the fact that the
firm is free to distribute these cash flows to

creditors and stockholders because these are the
cash flows that are left over after a firm has made
necessary investments in working capital and
long term assets.

Flows
The FCF Calculation
FCF = [(Revenue Op Exp D&A) x (1 t)]
+ D&A Cap Exp Add WC
(11.2)

Flows
The FCF Example
The truck you are considering to purchase for your
business will increase revenues $50,000 and
operating expenses $30,000 in the next year.
Depreciation and amortization charges for the truck
will equal $10,000 next year, and your firms
marginal tax rate will be 35 percent. Capital
expenditures will be $3,000 and no working capital
will be needed. Calculate the free cash flow.
FCF=[($50,000 - $30,000 - $10,000)(1-0.35)]
+ $10,000 - $3,000 - $0 = $13,500
Exhibit 11.1: The Free CashFlow Calculation

Flows
The FCF Calculation
We first compute the incremental cash flow from
operations (CF Opns), which is the cash flow that

the project is expected to generate after all
operating expenses and taxes have been paid.
We then subtract the incremental capital
expenditures (Cap Exp) and incremental

additions to working capital (Add WC) required for
the project to obtain FCF.
10
Exhibit 11.2: FCF Calculation

Worksheet
11
Exhibit 11.3: Completed FCF

Calculation Worksheet
12

Flows
The FCF Calculation
The FCF is therefore a measure of the after-tax
cash flows from operations over and above what

is necessary to make any required investments.
13

Flows
The FCF Calculation
The idea that we can evaluate the cash flows
from a project independently of the cash flows for

the firm is known as the stand-alone principle. It
is another way of saying that we can treat the
project as if it is a stand-alone firm that has its
own revenue, expenses, and investment
requirements.
14

Flows
The Cash Flows from Operations
Note that the incremental cash flow from
operations, CF Opns, equals the incremental net

operating profits after tax (NOPAT) plus the
incremental depreciation and amortization (D&A)
associated with the project.
We exclude interest expenses when calculating
NOPAT because the cost of financing a project is

reflected in the discount rate that is used in the
NPV calculation.
15

Flows
We use the firms marginal tax rate (t) to calculate
NOPAT because the profits from a project are

assumed to be incremental to the firm.
16

Flows
We add incremental depreciation and
amortization (D&A) to NOPAT when calculating

CF Opns because, as in the accounting statement
of cash flows, D&A represents a non-cash charge
that reduces the firms tax obligation.
However, since D&A is a non-cash charge, we
have to add it back to NOPAT in order to get the
cash flow from operations right.
17

Flows
Cash Flows Associated with Investments
Once we have estimated CF Opns, we simply
subtract cash flows associated with required

investment to obtain FCF for a project in a
particular period.
Investments can be required to purchase long-
term tangible assets, intangible assets, or to fund

current assets.
18

Flows
FCF versus Accounting Earnings
The impact of a project on a firms overall value or
on its stock price does not depend on how the

project affects the companys accounting
earnings. It depends only on how the project
affects the companys free cash flows.
Accounting earnings can differ from cash flows for
a number of reasons, making accounting

earnings an unreliable measure of the costs and
benefits of a project.
19
Using Excel Performing Arts

Center Project
20
Using Excel Performing Arts

Center Project (Formula Setup)
21

Flows
FCF versus Accounting Earnings
Accounting earnings also reflect non-cash
charges, such as depreciation and amortization,

which are intended to account for the costs
associated with deterioration of the assets in a
business as those assets are used.
22
Estimating Cash Flows in

Practice
Five General Rules for Incremental Cash-Flow
Calculations
Rule 1: Include cash flows and only cash flows in
your calculations. Do not include allocated costs

or overhead unless they reflect cash flows.
Rule 2: Include the impact of the project on cash
flows from other product lines. If the product

associated with a project is expected to cannibalize
or boost sales of another product, you must include
the expected impact of the new project on the cash
flows from the other product in the analysis.
23

Practice
Calculations
Rule 3: Include all opportunity costs. By
opportunity costs, we mean the cost of giving up

another opportunity.
Rule 4: Forget sunk costs. Sunk costs are costs
that have already been incurred but all that matters

when you evaluate a project at a particular point in
time is future investment and what you expect to
receive in return for that investment; this means
that past investments are irrelevant.
24

Practice
Calculations
Rule 5: Include only after-tax cash flows in the
cash-flow calculations. The incremental pre-tax

earnings of a project only matter to the extent that
they affect the after-tax cash flows that the firms
investors receive.
25
Exhibit 11.4: Adjusted FCF

Calculations and NPV
26

Practice
Nominal versus Real Cash Flows
Nominal dollars are the dollars that we typically
think of. They represent the actual dollar amounts

that we expect a project to generate in the future,
without any adjustments.
When prices are going up, a given nominal dollar
amount will buy less and less over time.

Real dollars represent dollars stated in terms of
constant purchasing power.

27

Practice
Nominal versus Real Cash Flows
As stated in the equation below, we can write the cost
of capital, k as:
1 + k = (1 + Pe)(1 + r)
(11.3)
Where:
k is the nominal cost of capital
Pe is the expected rate of inflation
r is the real cost of capital
It is important to make sure that all cash flows are
stated in either nominal dollars or real dollars.

28

Practice
Nominal versus Real Cash Flows Example
A project will require an initial investment of
$50,000 in year 0 and will produce FCFs of
$20,000 a year in years 1 through 4. With a 15
percent nominal cost of capital, the NPV of the
project is:
$20,000
$20,000
$20,000
$20,000
NPV= -$50,000 +
+
+
+
1.15
(1.15)2
(1.15)3
(1.15)4
= -$50,000 + $17,391 + $15,123 + $13,150 + $11,435
= $7,099
29

Practice
Nominal versus Real Cash Flows Example - Continued
Using Equation 11.3 when the expected rate of
inflation is 5 percent we can calculate the real cost
of capital as:
1 k
1.15
r
1
1 0.09524,or 9.524%
1 Pe
1.05
30

Practice
Nominal versus Real Cash Flows Example - Continued
The real cash flows for the project are as follows:
Year 0
Year 1
Year 2
Year 3
Year 4
$20,000
$20,000 $20,000
$20,000
-50,000
1+0.05
(1+0.05)2 (1+0.05)3
(1+0.05)4
-50,000 =$19,047.6 =$18,140.6 =17,276.8 =$16,454.0
$19,047.6 $18,140.6 $17,276.8 $16,454

NPV =-$50,000+
+
+
+
2
3
1.09524 1.09524
1.09524
1.09524 4
=-$50,000+$17,391+15,123+13,150+$11,435 = $7,099
31

Practice
Taxes and Depreciation
A progressive tax system, which we have in the
United States, is one in which the marginal tax

rate at low levels of income is lower than the
marginal tax rate at high levels of income.
32
Exhibit 11.5: U.S. Tax Rate

Schedule
33
Exhibit 11.6: U.S. Corporate

Tax Rate Schedule
34

Practice
One especially important difference from a capital
budgeting perspective is that the depreciation

methods allowed by GAAP differ from those
allowed by the IRS.
The straight-line depreciation method illustrated
earlier in this chapter in the performing arts center

example is allowed by GAAP and is often used
for financial reporting.
35

Practice
An accelerated method of depreciation, called
the Modified Accelerated Cost Recovery System

(MACRS), has been in use for U.S. federal tax
calculations since the Tax Reform Act of 1986
went into effect.
MACRS thus enables a firm to deduct
depreciation charges sooner, thereby realizing the

tax savings sooner and increasing the present
value of the tax savings.
36
Exhibit 11.7: MACRS

Depreciation Schedules
37
Exhibit 11.8: MACRS

Depreciation Calculations
38

Practice
Computing Terminal-Year FCF
The FCF in the last, or terminal, year of a project
often includes cash flows that are not typically

included in the calculations for other years.
For instance, in the final year of a project, the
assets acquired during the life of the project may

be sold and the working capital that has been
invested may be recovered.
39

Practice
Computing Terminal-Year FCF
The equation below shows that we can calculate
the additions to working capital (Add WC) as:
Add WC = Change in Cash and cash equivalents +
Change in Accounts receivable + Change in

Inventories Change in Accounts payable (11.4)
When an asset is expected to have a salvage
value, we must include the salvage value realized
from the sale (net of any tax consequences) of
the asset and the impact of the sale on the firms
taxes in the terminal-year FCF calculations.
40
Exhibit 11.9: FCF

41
Exhibit 11.10: FCF

42

Practice
Expected Cash Flows
It is important to realize that in an NPV analysis
we use the expected FCF for each year of the life

of the project.
Each FCF is a weighted average of the cash
flows from each possible future outcome, where

the cash flow from each outcome is weighted by
the estimated probability that the outcome will be
realized.
43
Exhibit 11.11: Expected

FCFs for New Board Game
44
Forecasting Free Cash Flows

Cash Flows from Operations
To forecast the incremental cash flows from
operations, we must forecast the incremental net

revenue, operating expenses, and depreciation
and amortization.
When forecasting operating expenses, analysts
often distinguish between variable costs, which

vary directly with unit sales, and fixed costs,
which do not.
45
Forecasting Free Cash Flows

Investment Cash Flows
Capital expenditures forecasts reflect the
expected level of investment during each year of

the projects life, including any inflows from
salvage values and any tax costs or benefits
associated with asset sales.
Four working capital items are included in the
cash flow forecasts of an NPV analysis: cash and

cash equivalents, accounts receivable,
inventories, and accounts payable.
46
Special Cases
Projects with Different Lives
An efficient method of solving capital budgeting
problems involving two mutually exclusive

projects with different lives is to compute the
equivalent annual cost (EAC).
(1+k)t
EACi = kNPVi
(1+k)t -1
(11.5)
where k is the opportunity cost of capital, NPVi is

normal NPV of the investment i, and t is the life of
the investment.
47
Special Cases
Projects with Different Lives
Find the EAC of two options: mower A, which costs
$250 and is expected to last two years, and mower
B, which costs $360 and is expected to last three
years. The cost of capital is 10 percent.
EAC A (0.1)( $250)
(1 0.1)2
EACB (0.1)( $360)
$144.05
(1 0.1) 1
(1 0.1)3
$144.76
3
(1 0.1) 1
2
48
Special Cases
When to Harvest an Asset
The optimal time to harvest is the point in time at
which the rate of increase in nominal NPV is no

longer greater than the cost of capital.
At this point in time, it becomes optimal to
harvest the trees and invest the proceeds in

alternative investments that yield the opportunity
cost of capital.
49
Special Cases
When to Replace an Existing Asset
Two fundamental questions: Do the benefits of
replacing the existing asset exceed the costs,

and if they do not now, when will they?
Solving this problem is simply a matter of
computing the EAC for the new asset and

comparing it with the annual cash inflows from
the old asset.
50
Special Cases
The Cost of Using an Existing Asset
The third rule of calculating incremental after-tax
cash flows is to include all opportunity costs that

are not always directly observable.
Sometimes they have to be computed by first
figuring the EAC for a given set of cash flows

and then adjusting the EAC by the appropriate
discount rate and time, if the EAC is not in
present-value form.
51

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Fundamentals of Corporate

Chapter 11 Cash Flows and Capital Budgeting

Copyright 2008 John Wiley & Sons

Chapter 11 Cash Flows and Capital Budgeting

Copyright 2008 John Wiley & Sons

Chapter 11 Cash Flows and Capital Budgeting

Copyright 2008 John Wiley & Sons

Calculating Project Cash

cash flows that a project is expected to produce in

Chapter 11 Cash Flows and Capital Budgeting

Copyright 2008 John Wiley & Sons

Calculating Project Cash

are the incremental after-tax free cash flows

Chapter 11 Cash Flows and Capital Budgeting

FCF without project (11.1)

Copyright 2008 John Wiley & Sons

Calculating Project Cash

firm is free to distribute these cash flows to

Chapter 11 Cash Flows and Capital Budgeting

Copyright 2008 John Wiley & Sons

Calculating Project Cash

+ D&A Cap Exp Add WC

Chapter 11 Cash Flows and Capital Budgeting

Copyright 2008 John Wiley & Sons

Calculating Project Cash

Copyright 2008 John Wiley & Sons

Exhibit 11.1: The Free CashFlow Calculation

Chapter 11 Cash Flows and Capital Budgeting

Copyright 2008 John Wiley & Sons

Calculating Project Cash

operations (CF Opns), which is the cash flow that

expenditures (Cap Exp) and incremental

Chapter 11 Cash Flows and Capital Budgeting

Copyright 2008 John Wiley & Sons

Exhibit 11.2: FCF Calculation

Chapter 11 Cash Flows and Capital Budgeting

Copyright 2008 John Wiley & Sons

Exhibit 11.3: Completed FCF

Chapter 11 Cash Flows and Capital Budgeting

Copyright 2008 John Wiley & Sons

Calculating Project Cash

cash flows from operations over and above what

Chapter 11 Cash Flows and Capital Budgeting

Copyright 2008 John Wiley & Sons

Calculating Project Cash

from a project independently of the cash flows for

Chapter 11 Cash Flows and Capital Budgeting

Copyright 2008 John Wiley & Sons

Calculating Project Cash

operations, CF Opns, equals the incremental net

We exclude interest expenses when calculating

NOPAT because the cost of financing a project is

Copyright 2008 John Wiley & Sons

Calculating Project Cash

NOPAT because the profits from a project are

Chapter 11 Cash Flows and Capital Budgeting

Copyright 2008 John Wiley & Sons

Calculating Project Cash

amortization (D&A) to NOPAT when calculating

Chapter 11 Cash Flows and Capital Budgeting

Copyright 2008 John Wiley & Sons

Calculating Project Cash

subtract cash flows associated with required