10: Cash Flow and Capital Budgeting10 -1 TYPES OF CASH FLOWS
In this section we learn how to differentiate between cash flow and accounting profit by focusing on
incremental cash flow – ignoring financing costs, considering taxes and adjusting for non-cash expenses.10 -1a CASH FLOW VErSUS ACCOUNTING PrOFIT
When accountants prepare financial statements for external reporting, they have a very different purpose
in mind than financial analysts do when they evaluate the merits of an investment. Accountants want to
produce financial statements that fairly and accurately represent the state of a business at any given time,
as well as over a period of time. Given this purpose, accountants measure the inflows and outflows of a
business’s operations on an accrual basis rather than on a cash basis. For example, accountants typically
credit a company for earning revenue once a sale is made, even though customers may not pay cash for
their purchases for several weeks or months. Similarly, accountants typically do not record the full cost
of an asset as an expense if they expect the asset to confer benefits to the company over several years. If
a company spends $1 billion on an asset that it plans to use over 10 years, accountants may count only
one-tenth of the purchase price, or $100 million, as a current-year depreciation expense.
In contrast, when they analyse an investment’s merits, financial analysts focus on the actual cash
inflows and outflows that the investment produces. In part, this is because no matter what earnings a
company may show on an accrual basis, it cannot survive for long unless its investments generate enough
cash to pay its bills. Furthermore, the emphasis that sound financial analysis places on cash flow reflects
the time value of money. If a company sells a product for $1,000, the value of that sale is greater if the
customer pays immediately rather than 30 or 90 days in the future.
This chapter shows you how to calculate the cash flows needed to estimate an investment’s net
present value (NPV). The key principles involved are:■ Include only the investment’s incremental cash flows.
■ Ignore an investment’s financing costs.
■ Focus on after-tax cash flows.
■ Adjust for non-cash expenses such as depreciation.
The following sections illustrate these principles.
Focusing on Incremental Cash Flows
For capital budgeting purposes, financial analysts and companies focus on incremental cash inflows and
outflows. Cash flows triggered by a particular investment that would not have otherwise occurred are
incremental cash flows. The cost of building and operating a new plant and the revenues from selling the
products produced at the plant are clear examples of incremental cash flows. However, some incremental
cash flows are more subtle, and can be easy to miss. For example, when a company launches a new
product line, revenues from older products may decline, and those lost sales represent an incremental
cash outflow. We will discuss incremental cash flows in more depth later in this chapter. For now,
recognise that identifying the cash flows that directly result from a proposed investment is a key step in
the analysis of investment opportunities.LO10.1
incremental cash flows
Cash flows triggered by an
investment that would not
have otherwise occurred