Incremental Cash Flows• Cash flows matter—not accounting earnings.• Sunk costs do not matter.• Incremental cash flows matter.• Opportunity costs matter.• Taxes matter: we want incremental after-tax

cash flows. • Inflation matters.

Cash Flows—Not Accounting Income

• Consider depreciation expense. – You never write a check made out to

“depreciation.”

• Much of the work in evaluating a project lies in taking accounting numbers and generating cash flows.

Incremental Cash Flows

• Sunk costs are not relevant• Opportunity costs do matter. Just because a

project has a positive NPV, that does not mean that it should also have automatic acceptance. Specifically, if another project with a higher NPV would have to be passed up, then we should not proceed.

Estimating Cash Flows

• Cash Flow from OperationsOCF = EBIT – Taxes + Depreciation

• Net Capital Spending– Do not forget salvage value (after tax, of course).

• Changes in Net Working Capital

Inflation and Capital Budgeting

• Inflation is an important fact of economic life and must be considered in capital budgeting.

• Consider the relationship between interest rates and inflation, often referred to as the Fisher equation:(1 + Nominal Rate) = (1 + Real Rate) × (1 + Inflation Rate)

Inflation and Capital Budgeting

• For low rates of inflation, this is often approximated: Real Rate Nominal Rate – Inflation Rate

• In capital budgeting, one must compare real cash flows discounted at real rates or nominal cash flows discounted at nominal rates.

Other Methods for Computing OCF• Bottom-Up Approach– Works only when there is no interest expense– OCF = NI + depreciation

• Top-Down Approach– OCF = Sales – Costs – Taxes– Do not subtract non-cash deductions

• Tax Shield Approach– OCF = (Sales – Costs)(1 – T) + Depreciation*T

Q.WT Ltd. is considering the purchase of a new paper cutting machine to replace an existing machine that has book value of Rs.15,000 and can be sold for Rs.7,500. The estimated salvage value of the old machine in 4 years would be zero, and it is depreciated on a straight line basis. The new machine will reduce costs (before tax) by Rs.35, 000 per year. The new machine has a life of 4 years, costing Rs.70,000 and can be sold for Rs.10,000 at the end of 4th year. It the tax rate applicable is 40% and straight line method is followed for tax purposes, should the machine be replaced if the discounting rate is 10%?

Q.ABC Constructions is building a block of 6 flats with a purpose to let out these flats at annual rental. The total cost of the project is estimated to be Rs.40,00,000 in terms of the price of the date when the flats will be ready for let out. The life of the flat may be taken at 25 years. What should be the minimum annual rental charged by the company for the first year given that:

1. Appropriate money discount rate is 18.8%2. Annual lease rental will increase in line with the general inflation which may be taken @8%p.a.

Investments of Unequal Lives

Q.SDF Ltd is evaluating two power systems: X and Y for its factory. The two systems will serve the same purpose but life of system X and Y are 7 years and 5 years respectively. The purchase price and the operating costs of the two machines are as under:

Year System X (Rs.) System Y (Rs.)0 10,00,000 8,00,0001 1,00,000 75,0002 1,25,000 1,00,0003 1,50,000 1,20,0004 1,75,000 1,40,0005 2,00,000 1,00,0006 2,25,0007 2,00,000

Which of the systems should be purchased if the cost of capital is 12% and the estimated salvage value of both the systems is expected to be zero?