Foundations of Finance

Tenth Edition, Global Edition

Chapter 11
Cash Flows and Other Topics in
Capital Budgeting

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Learning Objectives
11.1 Identify guidelines by which we measure cash flows.
11.2 Explain how a project’s benefits and costs—that is, its
free cash flows—are calculated.
11.3 Explain the importance of options, or flexibility, in
capital budgeting.
11.4 Understand, measure, and adjust for project risk.

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Guidelines for Capital Budgeting

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Guidelines for Capital Budgeting
• To evaluate investment proposals, we must first set
guidelines by which we measure the value of each
proposal.
• We must know what is and what isn’t relevant cash flow.

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Use Free Cash Flows Rather Than
Accounting Profits
• 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.

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Think Incrementally
• 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.

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Beware of Cash Flows Diverted
from Existing Products
• 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.

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Look for Incidental or Synergistic
Effects
• Although some projects may take sales away from a firm’s
existing projects (such as introducing a new flavor of ice
cream), in other cases new projects may add sales to the
existing line (such as adding a coffee store to an existing
retail store).
• This is called synergistic effect and is a relevant cash flow.

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Work in Working-Capital
Requirements
• 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.

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Consider Incremental Expenses
• Similar to cash inflows, cash outflows must also be
considered on an incremental basis.
• For example, replacing an existing equipment may require
training expense (an incidental expense) for current
employees on the new equipment.

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Sunk Costs Are Not Incremental
Cash Flows
• Sunk costs are cash flows that have already occurred
(such as marketing research) and cannot be undone. Any
cash flows that are not affected by the accept/reject
criterion should not be included in the analysis.
• 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.

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Account for 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.

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Decide If Overhead Costs Are Truly
Incremental Cash Flows
• 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,
utilities bill may have been the same with or without the
project).

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Ignore Interest Payments and
Financing Flows
• 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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Calculating a Project’s Free Cash
Flows

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Free Cash Flow Calculations
• Three components of free cash flows
– Initial outlay,
– Annual free cash flows over the project’s life
– Terminal free cash flow

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Initial Cash Outlay (1 of 2)
• The initial cash outlay is the immediate cash outflow
necessary to purchase the asset and put it in operating
order.
• This outlay includes the following:
1. Purchase cost, set-up cost, installation,
shipping/freight, training cost
2. Increased working-capital requirements
3. Sale of existing asset and tax implications (if the
project replaces an existing project/asset)

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Initial Cash Outlay (2 of 2)
Initial cost of sales price taxes recovered or paid from a loss
= − +/−
outlay new asset of theold asset or gain on thesaleof theold asset

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Annual Free Cash Flows
• Annual free cash flows is the incremental after-tax cash
flows resulting form 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
(1 of 3)

• Step 1: Measure the project’s change in after-tax

operating cash flows.
• Operating cash flows
= Changes in EBIT − Changes in taxes + Change in
depreciation
• Note, depreciation is a noncash expense but influences
the cash flows through tax effects.
– Higher depreciation expense lowers firm’s profits,
which lowers taxes.

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Calculating Operating Cash Flows
(2 of 3)

• Step 2: Calculate the cash flows from the change in net

working capital.
• This refers to additional investment in current assets
minus any additional short-term liabilities that were
generated.

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Calculating Operating Cash Flows
(3 of 3)

• Step 3: Determine the cash flows from the changes in

capital spending.
• This refers to any capital spending requirements during
the life of the project.

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Putting It All Together
• Step 4: Project free cash flows = change in E B I T −
changes in taxes + change in depreciation − change in net
working capital − changes in capital spending

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

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Table 11.1 Calculating the Annual Change
in Earnings Before Interest and Taxes for
the Press-on Abs Project (1 of 2)

Year 1 (the year in which Bonus Depreciation appears): Blank

Δ Sales (100,000 units at $6.00/unit) $600,000
Less: Δ Variable costs (variable cost $3.00/unit) $300,000
Less: Δ Fixed costs $ 90,000
Equals: E B I T D A (assuming amortization is 0) $210,000
Less: Δ Depreciation ($200,000) using Bonus Depreciation $200,000
Equals: Δ E B I T $ 10,000
Less: Δ Taxes: (taxed at 21%) $ 2,100
Equals: Δ Net income $ 7,900

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Table 11.1 Calculating the Annual Change
in Earnings Before Interest and Taxes for
the Press-on Abs Project (2 of 2)

Years 2 and 3 (years without Depreciation): Blank

Δ Sales (100,000 units at $6.00/unit) $600,000
Less: Δ Variable costs (variable cost $3.00/unit) $300,000
Less: Δ Fixed costs $ 90,000
Equals: E B I T D A (assuming amortization is 0) $210,000
Less: Δ Depreciation (Bonus Depreciation taken in year 1) $ 0
Equals: Δ E B I T $210,000
Less: Δ Taxes: (taxed at 21%) $ 44,100
Equals: Δ Net income $165,900

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Table 11.2 Calculating the Annual Change
in Operating Cash Flow, Press-on Abs
Project

Year 1 (the year in which Bonus Depreciation appears): Blank

Δ Sales (100,000 units at $6.00/unit) $600,000
Minus: Δ Taxes $ 2,100
Plus: Δ Depreciation $200,000
Equals: Δ Operating cash flow $207,900
Years 2 and 3 (all the Depreciation was taken in year 1
under Bonus Depreciation):
Δ Earnings before interest and taxes (E B I T) $210,000
Minus: Δ Taxes $ 44,100
Plus: Δ Depreciation $ 0
Equals: Δ Operating cash flow $165,900
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Table 11.3 Calculating the Terminal
Free Cash Flow, Press-on Abs Project

Δ Earnings before interest and taxes $210,000

(E B I T)
Minus: Δ Taxes $ 44,100
Plus: Δ Depreciation $ 0
Minus: Δ Net working capital ($30,000)*
Equals: Δ Free cash flow $195,900

*Because the change in net working capital is negative (we are reducing our investment
in inventory), we are subtracting a negative number, which has the effect of adding it
back in.
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Figure 11.1 Free Cash Flow Diagram
for Press-on Abs

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A Comprehensive Example:
Calculating Free Cash Flows
• Raymobile is considering a scooter line
• Tax bracket: 21% (no state income tax)
• Required rate of return: 15%
1. Estimate cash flows
2. Calculate NPV
3. Calculate profitability ratio
4. Calculate IRR
5. Make a decision

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Table 11.4 Raymobile Scooter Line
Capital-Budgeting Example

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Table 11.5 Calculating the Free Cash
Flow for Raymobile Scooters (1 of 2)

1We are assuming that Ravmobile has sufficient profits in other areas to allow it to use the
loss in year 1 to offset taxes due in other areas.
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Table 11.5 Calculating the Free Cash
Flow for Raymobile Scooters (2 of 2)

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Figure 11.2 Free Cash Flow Diagram
for the Raymobile Scooter Line

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Options in Capital Budgeting

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Options in Capital Budgeting
• Options add value to capital-budgeting projects by being
able to modify the project based on future developments
(that are currently unknown). Three options are common:
– Option to delay a project
– Option to expand a project
– Option to abandon a project

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The Option to Delay
• Almost every project has a mutually exclusive
alternative—waiting and pursuing at a later time.
• It is conceivable that a project with a negative NPV now
may have a positive NPV if undertaken later on. This
could be due to various reasons, such as favorable
changes in fashion, technology, economy, or borrowing
costs.

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The Option to Expand
• Even if a project is currently unprofitable, it may be useful
to determine whether the profitability of the project will
change if the company is able to expand in the future.
• For example, a firm may choose to invest in a negative
NPV project to gain access to new market.

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The Option to Abandon
• It may be necessary to abandon the project before its
estimated life due to inaccurate project analysis models or
cash flow forecasts or due to changes in market
conditions.
• When comparing two projects with similar NPVs, a project
that is easier to abandon may be more desirable (for
example, hiring temporary versus permanent workers,
leasing versus buying a car). The option to abandon
infuses flexibility, which is desirable.

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Risk and the Investment Decision

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Figure 11.3 A Free Cash Flow
Diagram Based on Possible
Outcomes

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Risk and the Investment Decision
• Two main issues
– What is risk in capital-budgeting decisions, and how
should it be measured?
– How should risk be incorporated into a capital-
budgeting analysis?

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Three Perspectives on Risk
• Project-standing-alone risk
• Contribution-to-firm risk
• Systematic risk

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Project-Standing-Alone-Risk
• This is a project’s risk ignoring the fact that much of the
risk will be diversified away as the project is combined
with other projects and assets.
• This is an inappropriate measure of risk for capital-
budgeting projects.

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Contribution-to-Firm Risk
• This is the amount of risk that the project contributes to
the firm as a whole.
• This measure considers the fact that some of the project’s
risk will be diversified away as the project is combined
with the firm’s other projects and assets but ignores the
effects of the diversification of the firm’s shareholders.

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Systematic Risk
• This is the risk of the project from the viewpoint of a well-
diversified shareholder.
• This measure takes into account that some of the risk will
be diversified away as the project is combined with the
firm’s other projects, and in addition, some of the
remaining risk will be diversified away by the shareholders
as they combine this stock with other stocks in their
portfolios.

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Figure 11.4 Looking at Three
Measures of a Project’s Risk

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Relevant Risk
• Theoretically, the only risk of concern to shareholders is
systematic risk.
• Because the project’s contribution-to-firm risk affects the
probability of bankruptcy for the firm, it is a relevant risk
measure.
• Thus we need to consider both the project’s contribution-
to-firm risk and the project’s systematic risk.

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Incorporating Risk into Capital
Budgeting
• We know that investors demand higher returns for more
risky projects.
• As the risk of a project increases, the required rate of
return is adjusted upward to compensate for the added
risk.
• This risk-adjusted discount rate is then used for
discounting free cash flows (in NPV model) or as the
benchmark required rate of return (in IRR model).

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Figure 11.5 The Risk–Return
Relationship

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Measuring a Project’s Systematic
Risk
• Estimating risk of a project can be difficult. Historical stock
return data relate to an entire firm rather than a specific
project or division. Risk must be estimated. Options to
estimate risk include the following:
– Accounting beta
– Pure play method
– Simulation
– Scenario analysis
– Sensitivity analysis

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Accounting Beta
• Accounting beta can be estimated via time-series
regression on a division’s return on assets on the market
index.
• How good is this measure? The correlation between
accounting beta and the beta calculated on historical
stock return data is only about 0.6.

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Pure Play Method
• Pure play method identifies publicly traded firms engaged
solely in the same business as the project or division.
• The systematic risk of the proxy firm or pure play firm is
used as a proxy for the project or division’s level of
systematic risk.

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Simulation
• Simulation involves the process of imitating the
performance of the project under evaluation (see Figure
11.6).
– Observations from each of the distributions that affect
the outcome of the project are selected randomly, and
this process is continued until a representative record
of the project’s probable outcome is assembled.

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Figure 11.6 Capital-Budgeting
Simulation

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Figure 11.7 Output from Simulation

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Sensitivity Analysis
• Sensitivity analysis involves determining how the
distribution of possible net present values or internal rate
of return for a particular project is affected by a change in
one particular input variable while holding all other input
variables constant (also known as what-if analysis).

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Key Terms
• Contribution-to-firm risk
• Initial outlay
• Project-standing-alone risk
• Pure play method
• Risk-adjusted discount rate
• Scenario analysis
• Sensitivity analysis
• Simulation
• Systematic risk

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