Capital budgeting decisions hinge on accurately estimating project cash flows. This crucial step involves identifying relevant, incremental cash flows that arise from undertaking a project, while excluding non-incremental flows that would occur regardless.

Proper cash flow estimation accounts for taxes, depreciation, and working capital impacts. By forecasting and discounting these flows, firms can calculate net present value and internal rate of return to make informed investment decisions that maximize shareholder value.

Estimating Cash Flows for Projects

Relevant Cash Flows for Capital Budgeting

• Involve evaluating potential investments or projects by analyzing cash inflows and outflows
• Determine net present value and potential return of the project
• Relevant cash flows are incremental cash flows that occur if the project is undertaken
  • Includes initial investment outlay
  • Includes any subsequent cash inflows or outflows that are a direct result of the project
• Measure relevant cash flows on an after-tax basis as taxes are a real cash outflow
  • Tax impact includes tax shield provided by depreciation
  • Tax impact includes any tax liabilities generated by the project

Costs Not Included in Cash Flow Estimation

• Opportunity costs are not included in the estimation of a project's cash flows
  • Costs of forgone opportunities
  • Not incremental cash flows
• Sunk costs have already been incurred, so they are not relevant to the decision
• Financing costs, such as interest expense, are not included
  • Financing costs are incorporated in the cost of capital used to discount the cash flows
• Include terminal value of the project in the final cash flow
  • Represents estimated value of project's assets at the end of its life
  • Discounted along with the other cash flows

Incremental vs Non-Incremental Cash Flows

Defining Incremental and Non-Incremental Cash Flows

• Incremental cash flows are additional cash flows that a firm experiences by taking on a project
  • Cash flows above and beyond what the firm would experience without the project
  • Incremental cash inflows might include additional revenue generated by the project
  • Incremental cash outflows could include initial investment, additional operating costs, or additional working capital requirements
• Non-incremental cash flows are cash flows that the firm would experience regardless of whether the project is undertaken
  • Not relevant to the capital budgeting decision
  • Fixed costs that do not change with the acceptance of the project, like overhead costs, are not incremental

Incremental Cash Flows for Replacement Projects

• If a project involves replacing an existing asset, incremental cash flows are the difference between:
  • Cash flows of the new project
  • Cash flows of the existing asset
• Cash flows of the existing asset are an opportunity cost

Taxes, Depreciation, and Working Capital Impacts

Accounting for Taxes and Depreciation

• Taxes have a significant impact on project cash flows and must be accounted for
  • Relevant tax rate is the marginal corporate tax rate (rate paid on company's next dollar of income)
• Depreciation is a non-cash expense but affects cash flows by providing a tax shield
  • Depreciation tax shield equals amount of depreciation times the marginal tax rate
  • Reduces taxes paid, increasing after-tax cash flow
• Choice of depreciation method (straight-line, accelerated, etc.) affects timing of tax shield and thus timing of cash flows
  • Accelerated depreciation provides greater tax shield in early years of the project

Working Capital Considerations

• Capital investments often require an investment in working capital
  • Includes inventory, accounts receivable, and accounts payable
  • Initial investment in working capital is a cash outflow
• As project generates sales, accounts receivable will increase (a use of cash)
• As project requires production, inventory will increase (a use of cash)
• Accounts payable are a source of cash
• At end of project, working capital is recovered, resulting in a cash inflow
  • Net investment in working capital over life of project is usually assumed to be zero

Forecasting and Discounting Cash Flows

Estimating Future Cash Flows

• Forecasting future cash flows involves estimating sales, costs, and investments for each year of project's life
  • Requires making assumptions about market conditions, competition, inflation, etc.
• Base cash flow projections on most likely or expected scenario, not best-case or worst-case scenario
  • Use sensitivity analysis to assess impact of changes in assumptions

Discounting Cash Flows and Making Investment Decisions

• Once cash flows have been estimated, they must be discounted to find present value
  • Discounting accounts for time value of money (a dollar today is worth more than a dollar in the future)
• Use project's cost of capital as discount rate
  • Minimum return that must be earned on project to leave firm's value unchanged
  • Represents opportunity cost of investing in the project
• Net present value (NPV) is found by summing present values of each cash flow
  • If NPV is positive, project is expected to increase shareholder value and should be accepted
  • If NPV is negative, project should be rejected
• Internal rate of return (IRR) is another method used to make investment decisions
  • Discount rate that makes NPV of project zero
  • If IRR is greater than cost of capital, project should be accepted