Capital budgeting decisions hinge on accurately estimating project cash flows. This crucial step involves identifying relevant, incremental cash flows that arise from undertaking a project, while excluding non-incremental flows that would occur regardless.
Proper cash flow estimation accounts for taxes, , and working capital impacts. By forecasting and discounting these flows, firms can calculate and to make informed investment decisions that maximize shareholder value.
Estimating Cash Flows for Projects
Relevant Cash Flows for Capital Budgeting
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Involve evaluating potential investments or projects by analyzing cash inflows and outflows
Determine net present value and potential return of the project
Relevant cash flows are incremental cash flows that occur if the project is undertaken
Includes initial investment outlay
Includes any subsequent cash inflows or outflows that are a direct result of the project
Measure relevant cash flows on an after-tax basis as taxes are a real cash outflow
Tax impact includes provided by depreciation
Tax impact includes any tax liabilities generated by the project
Costs Not Included in Cash Flow Estimation
Opportunity costs are not included in the estimation of a project's cash flows
Costs of forgone opportunities
Not incremental cash flows
Sunk costs have already been incurred, so they are not relevant to the decision
Financing costs, such as interest expense, are not included
Financing costs are incorporated in the cost of capital used to discount the cash flows
Include terminal value of the project in the final cash flow
Represents estimated value of project's assets at the end of its life
Discounted along with the other cash flows
Incremental vs Non-Incremental Cash Flows
Defining Incremental and Non-Incremental Cash Flows
Incremental cash flows are additional cash flows that a firm experiences by taking on a project
Cash flows above and beyond what the firm would experience without the project
Incremental cash inflows might include additional revenue generated by the project
Incremental cash outflows could include initial investment, additional operating costs, or additional working capital requirements
Non-incremental cash flows are cash flows that the firm would experience regardless of whether the project is undertaken
Not relevant to the capital budgeting decision
Fixed costs that do not change with the acceptance of the project, like overhead costs, are not incremental
Incremental Cash Flows for Replacement Projects
If a project involves replacing an existing asset, incremental cash flows are the difference between:
Cash flows of the new project
Cash flows of the existing asset
Cash flows of the existing asset are an opportunity cost
Taxes, Depreciation, and Working Capital Impacts
Accounting for Taxes and Depreciation
Taxes have a significant impact on project cash flows and must be accounted for
Relevant tax rate is the marginal corporate tax rate (rate paid on company's next dollar of income)
Depreciation is a non-cash expense but affects cash flows by providing a tax shield
Depreciation tax shield equals amount of depreciation times the marginal tax rate