Cash Flows

Cash Flows

Capital budgeting is concerned with cash flows. This focus on cash flows distinguishes capital budgeting from cost accounting, which treats profits and losses. For example, a purchase of equipment for $1 million cash is a current cash outflow of $1 million. However, if the equipment is depreciated by the straight line method over a period of 10 years to zero salvage value, its current cost is only $100,000. The balance of $900,000 shows up on the company’s annual income statements for the next nine years as a depreciation cost of $100,000. Accumulated depreciation is shown on the balance sheet.

The cash flows associated with a project’s capital budgeting analysis must be the incremental cash flows associated with the project. In other words, the relevant cash flows are those that occur in addition

to those that the firm already has, or would continue to have if the project were not undertaken. For example, if introducing a new product reduces the sales revenues from an existing product, the relevant cash flow is only the increase in sales revenues—that is, the incremental cash flow is the sales revenue generated by the new product minus its impact on decreasing sales for an old product.

Cash flows should, of course, include the effects of depreciation and taxes, which are discussed in the preceding chapter. Calculations of an investment’s net present value, rate of return, and payback period must be based on after-tax rather than before-tax cash flows. Determining the before-tax and after- tax cash flows is the key to capital budgeting.

Sunk costs should not be included in a project’s cash flow analysis. Sunk costs are those that have been incurred in the past and cannot be recovered. Financing costs should also not be included in the cash flow analysis. Though important, financing costs are implicitly included in the discount rate that is used to evaluate a project’s net present value and rate of return.

Cash flow streams have three phases: (1) an initial outlay, (2) future cash flows, and (3) a terminal cash flow. These are discussed in the sections that follow.

366 ❧ Corporate Financial Analysis with Microsoft Excel ®

Initial Outlay The initial outlay is the cash outflow that occurs at time zero (i.e., the beginning of the project). Initial

outlays include all costs to get a project up and running. For example, the initial outlay for new equip- ment includes not only the price paid for it but also any shipping and installation expenses, plus the cost of training employees to operate the equipment. As another example, the initial outlay for a building includes not only the price paid to the seller but also any fees paid to a broker and any costs for remodel- ing to make the building suitable for its intended use. The sum of these costs is the depreciable base for the project. It is the amount that will be depreciated over the life of the project.

When new equipment is purchased to replace existing equipment, the amount received from selling the old equipment must be considered in calculating the initial outlay. This may involve tax consider- ations. When the market value or selling price of the old equipment exceeds its book value (i.e., its tax base minus accumulated depreciation), taxes must be paid on the difference, which represents a capital gain. On the other hand, when the selling price of the old equipment is less than its book value, there is

a capital loss that reduces the firm’s taxable income. Prepaid expenses associated with the new capital asset (e.g., “up-front” payments on contracts for maintenance and other services) may also be included in the initial cash outflow.