3. Capital Budgeting, Cash Flows, FCF

Definition of incremental cash flows

• Incremental cash flows are all cash flows that change because the project is undertaken

• Compare “with project” vs “without project” situations

Treatment of sunk costs in capital budgeting

• Sunk costs are past outlays that cannot be recovered

• They are ignored in project evaluation because they do not change with the current decision

Treatment of opportunity costs in capital budgeting

• Opportunity costs are benefits from the best alternative use of an asset

• They are included as project cash outflows even if no explicit payment occurs

Treatment of allocated overhead in project analysis

• Only overhead that increases due to the project is included

• Pure accounting allocations of existing fixed costs are excluded from incremental cash flows

Definition of Net Working Capital in projects

• NWC is the operating liquidity tied up in the business, used to used to fund the timing gap between paying suppliers and collecting cash from customers and paying immediate obligations

• Practically inventory plus trade receivables minus trade payables, capturing the capital required to run day-to-day operation

Effect of changes in Net Working Capital on cash flows

• Increases in net working capital are cash outflows because more money is tied up in operations

• Decreases release cash and are inflows

High level definition of Free Cash Flow to Firm

• FCFF is cash generated by operations after taxes and necessary investment in fixed assets and working capital

• It is available to both debt and equity holders before financing decisions

Why interest expense is excluded from FCFF

• FCF measures performance of assets independent of financing

• Interest is a transfer between debt and equity holders and is captured through the discount rate not inside FCF

Salvage value and taxes concept

• When an asset is sold any difference between sale price and book value is a taxable gain or loss

• Tax is applied only to that gain or loss

Role of depreciation in project cash flows

• Depreciation itself is non cash

• It lowers taxable income and creates a tax shield which increases free cash flow

Treatment of R&D expenses in capital budgeting

• Past R&D already spent is a sunk cost and ignored

• Future R&D needed for the project is treated as an investment cash outflow

Break even analysis in capital budgeting

• BEP analysis finds the sales level or quantity where a project just earns zero NPV or zero profit

• Helps assess how sensitive value is to demand

Scenario analysis vs sensitivity analysis

• Scenario analysis changes several inputs together to form coherent cases like best base and worst

• Sensitivity analysis changes one input at a time to see how NPV reacts

Decision when a project uses an existing asset that could be sold

• Treat the current sale value of the asset as an opportunity cost of keeping it for the project

• Compare NPV of selling today vs. using it in the project

What happens to project NPV if terminal value is overstated?

• NPV is overstated (too high), sometimes by a lot.

• Risk: you may accept bad projects that look good only because of an inflated terminal value.

  • Example: If terminal value is 50% of total PV and you overstate it by 20%, NPV is badly biased upwards

What is the usual order of steps to build a project FCF table?

1. Forecast revenues and operating costs

2. Compute EBIT and taxes

3. Add back depreciation (non-cash)

4. Subtract CAPEX (new investments)

5. Subtract ΔNWC (extra cash tied up)

When should we treat a payment as CAPEX instead of an operating expense?

• When it creates or improves a long-lived asset

• Benefits several future years, not only the current year

Can we use a profitability index when the constraint is not money?

• Yes – use NPV per unit of the scarce resource, e.g.:

  • NPV per scientist

  • NPV per machine hour

• Then rank projects by this ratio

  • Example:

    • Project A: NPV 1m, uses 10 scientists → 0.1m per scientist.

    • Project B: NPV 0.6m, uses 3 scientists → 0.2m per scientist → better under scientist constraint

How do you decide whether to hire more of a scarce resource, like scientists?

• Compute extra NPV that one more unit of resource would allow

• Compare with cost per unit (salary etc.)

• Hire more as long as extra NPV > cost

  • Example: Extra scientist costs 100k/year and enables extra projects with NPV 150k → good hire

When is information “not enough” to compute incremental profit for a new product?

• When you don’t know:

  • Profit per unit of the old product

  • Number of old units lost due to cannibalization

• Then you can’t measure the true lost profit, so incremental profit is unknown

  • Example:New drink steals 20k units from old drink, but margin of old drink is unknown → you can’t compute incremental profit