Investment Decisions

-Free Cash Flow-

Use free cash flows

Free cash flow accurately reflects the timing of benefits
and costs when money is received, when it can be
reinvested, and when it must be paid out.
Accounting profits do not reflect actual money in hand.

Incremental cash flows

Further, after-tax free cash flows must be measured

incrementally.
Determining incremental free cash flow involves
determining the cash flows with and without the
project. Incremental is the additional cash flows
(inflows or outflows) that occur due to the project.

Beware of diverted cash flows

Not all incremental free cash flow is relevant.

Thus new product sales achieved at the cost of losing sales from
existing product line are not considered a benefit.
However, if the new product captures sales from competitors or
prevents loss of sales to new competing products, it would be a
relevant incremental free cash flow.

Incidental or Synergistic Effects

Although some projects may take sales away from a
firms current projects, in other cases new products
may add sales to the existing line. This is called a
synergistic effect and is a relevant cash flow.

Working capital requirement

New projects require infusion of working capital (such as
inventory to stock the shelves), which would be an
outflow.
Generally, when the project terminates, working capital
is recovered and there is an inflow of working capital.

Sunk Costs

Sunk costs are cash flows that have already occurred

(such as marketing research) and cannot be undone.
Sunk costs are considered irrelevant to decision
making.

Managers need to ask two basic questions:

1.

Will this cash flow occur if the project is accepted?

2. Will this cash flow occur if the project is rejected?

If the answer is Yes to #1 and No to #2, it will be

an incremental cash flow.

Opportunity Costs
Opportunity cost refers to cash flows that are lost
because of accepting the current project.
For example, using the building space for the project
will mean loss of potential rental revenue.

Overhead Costs
Incremental overhead costs or costs that were
incurred as a result of the project and relevant to
capital budgeting must be included.
Note, not all overhead costs may be relevant (for
example, the utilities bill may have been the same
with or without the project).

Interest Payments and Financing Costs

Interest payments and other financing cash flows
that might result from raising funds to finance a
project are not relevant cash flows.
Reason: Required rate of return implicitly accounts
for the cost of raising funds to finance a new project.

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Free Cash Flow Calculations

Free Cash Flow Calculations

Three components of free cash flows:

1.

Initial outlay

2. Annual free cash flows over the projects life

3. Terminal cash flow/Salvage value

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Initial Cash Outlay

The immediate cash outflow necessary to purchase
the asset and put it in operating order.
May include: Purchase cost, Set-up cost, Installation,
Shipping/Freight, increased working-capital requirements, tax
implications (if the project replaces an existing project/asset)

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Sale and Taxes

If Sale = Book Value
==> No tax effect
If sale >BV
==> recaptured depreciation, taxed as ordinary income
If sale < BV
==> capital loss ==> tax savings

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Annual Free Cash Flows

Annual free cash flow is the incremental after-tax cash
flow resulting from the project being considered.
Free Cash flow considers the following:
Cash flow from operations
Cash flows from working capital requirements
Cash flows from capital spending

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Calculating Operating Cash Flows

Measure the projects change in operating cash
flows
Operating cash flows=
Changes in EBIT

- Changes in taxes
+ Change in depreciation
Note, depreciation is a non-cash expense but influences the
cash flows through impact on taxes.

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Terminal Cash Flow

Terminal cash flows are flows associated with the
project at termination.
It may include:
Salvage value of the project.
Any taxable gains or losses associated with the sale of any asset.

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