Incremental Cash Flows and Operating Cash Flow in Capital Budgeting

Posted on Jan 28, 2025 in Economy

CH9 Slides: Discounted Incremental Cash Flows

Incremental cash flow = Cash flow with project – Cash flow without project

Would the cash flow still exist if the project did not exist?

  • If yes, do not include it in your analysis.
  • If no, include it.

Incremental Cash Flow

Include all indirect effects – positive and negative side effects.

Example: Producing a new economy car will generate more profitable future sales as customers become attached to your brand – a positive side effect.

Example: Developing a new jumbo jet line will erode some sales of existing lines – a negative side effect.

  • Forget sunk costs.

Example: If you have already paid for a marketing study, the cost already paid (i.e., sunk) should have no bearing on your calculations or decisions.

  • Include opportunity costs.

Example: If you own a piece of land that you will use to build a factory, the value of that land must be treated as a cost.

  • Recognize the investment in working capital.

The incremental net working capital, added current assets less added current liabilities, represents relevant cash-flow costs of initiating a project and should be part of the NPV analysis. Working capital recovered at the end of the project is a relevant cash flow.

Separation of Investment and Financing Decisions

  • When the cash flows of an investment are analyzed, how the investment is financed, or the financing costs of the project, is ignored.
  • How the project is financed, and the financing costs, are variables affecting the opportunity rate of return, used to discount the cash flows.
  • The value of the investment is considered by itself, independent of financing choice.

Operating Cash Flow (OCF)

Incremental cash flows from operations may be calculated in three ways:

(i) Dollars in minus dollars out

OCF = Revenues – Cash expenses – Taxes

(ii) Adjusted accounting profits

OCF = Net income + Depreciation

(iii) Add back depreciation tax shield

OCF = (Revenues – Cash expenses) x (1 – Tax rate) + (Tax rate x Depreciation)

What is OCF?

  1. OCF = Revenues – Cash expenses – Taxes
  2. OCF = Net income + Depreciation
  3. OCF = (Revenues – Cash expenses) x (1 – Tax rate) + (Tax rate x Depreciation)

Depreciation

  • The depreciation expense used for capital budgeting should be the depreciation schedule required by the IRS for tax purposes.
  • Depreciation itself is a non-cash expense; consequently, it is only relevant because it affects taxes.

Depreciation tax shield = D * T

D = Depreciation expense

T = Marginal tax rate

Straight-Line Depreciation

D = (Initial cost – Book value) / Number of years

Very few assets are depreciated straight-line for tax purposes.

MACRS (Modified Accelerated Cost Recovery System)

  • Need to know which asset class is appropriate for tax purposes.
  • Multiply the percentage given in the table by the initial cost.
  • Depreciate to zero.
  • The mid-year convention causes depreciation expense to be taken in one more year than specified by the property class.
Depreciation Tax Shield Comparison

The MACRS provides a faster depreciation rate and tax shield recovery compared to the straight-line depreciation rate, which provides for equal depreciation amounts over the useful life of the project. The MACRS depreciation tax shield affects cash flow and is relevant for capital budgeting analysis.