ADMS 3530 Winter 2012 – Professor Lois King
Lecture 7 – Capital Budgeting I – Feb 14
7.1 Identifying Relevant Cash Flows
− There are 9 basic rules for identifying relevant cash flows for DCF analysis:
o Rule 1: discount cash flows, not accounting profits.
Recognize expenses and revenues as they occur, not later when they show
up for accounting purposes.
You have to be especially careful to ignore noncash items such as
depreciation and accruals.
o Rule 2: discount incremental cash flows.
Incremental cash flows = cash flows with the projects – cash flows
without the project.
o Rule 3: include all indirect effects.
Bad indirect effect ▯a new product damages sales of the firm’s existing
Good indirect effect ▯the additional parts and maintenance revenues that
the sale of a new engine would provide to an aircraft manufacturer.
o Rule 4: forget sunk costs
All historical costs are sunk costs and will remain the same whether the
project is accepted or rejected. Therefore, they should not be included in a
project’s cash flows.
o Rule 5: include opportunity costs
Opportunity costs are benefits or cash flows foregone as the result of
going ahead with a project.
• Example: the market value (not cost base) of land that is owned by
a company, who is evaluating whether or not to build a new plant,
should be included in the DCF analysis.
o Rule 6: include the investment in net working capital
Net working capital = shortterm assets – shortterm liabilities.
Shortterm assets include cash, accounts receivables and inventories.
Shortterm liabilities include notes payable and accounts payable.
Investments (or increases) in net working capital (e.g. if inventories are
being increased), are just like investments in plant and equipment, result in
o Rule 7: be aware of allocated overhead costs You should include only extra overhead expenses that result from a
o Rule 8: discount nominal cash flows by the nominal interest rate
If using ‘real’ cash flows, discount by the real interest rate.
o Rule 9: separate investment and financing decisions.
First assess a project as if it were allequity financed.
Do not include any interest or debt payments incurred as a result of project
7.2 Basic Steps in DCF analysis
− Step 1 – Identify all relevant project cash flows.
− Step 2 – Separate the cash flows into 4 main categories:
o Plant & equipment.
o Net working capital.
o Cash flow from operations.
Method 1: CFop = revenues – cash expenses – taxes paid
Method 2: CFop = net profit (after tax) + depreciation
Method 3: CFop = (revenues – cash expenses) * (1 – t) + (depr. * t)
o Salvage value.
− Step 3 – Determine the cost of capital.
− Step 4 – Discount all relevant cash flows.
− Step 5 – Find NPV and if NPV > 0 then proceed with the project.
− Note on deprecation:
o Recall from module 7.1
We do not include depreciation in our project cash flows (as it is a noncash
We need to add it back to our cash flow number if we are trying to
calculate our cash flows from accounting income (where it has been
However because we are allowed to use deprecation (or CCA) to reduce
our taxes payable, depreciation savings do affect cash flow and we do
have to incorporate this tax savings which is called the CCA tax shield.
7.3 Review of Depreciation & CCA
o A noncash expense that reduces the value of an asset as a result of wear and tear,