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101 Concepts for the Level II Exam

Level II Concept 34: Capital budgeting: Determining cash flows


The cash flows relevant to an investing decision are the incremental cash flows i.e. the cash flows the company realizes with the investment compared to the cash flows the company would realize without the investment.

An expansion project is an independent investment that does not affect the cash flows for the rest of the company. In a replacement project we evaluate if it is profitable to replace existing equipment with new equipment by considering the incremental cash flows.

The cash flows can be grouped into 1) the investment outlays, 2) after-tax operating cash flows over the project’s life, and 3) terminal year after-tax non-operating cash flows

For an expansion project:

Outlay = FCInv + NWCInv

CF = (S – C – D) (1 – T) + D = (S – C)(1 – T) + TD

TNOCF = SalT + NWCInv – T(SalT – BT)

 

For a replacement project:

Outlay = FCInv + NWCInv – Sal0 + T (Sal0 – B0)

CF = (S – C – D) (1 – T) + D = (S – C)(1 – T) + TD

TNOCF = SalT + NWInv – T (SalT – BT)

Accelerated depreciation generally improves the NPV of a capital project compared to straight-line depreciation.