Introduction to Corporate Finance

PArT 3: CAPITAL BUDGETING

10-2 INCrEMENTAL CASH FLOWS

We have seen that many investment problems have similar types of cash flows that analysts must

estimate: initial outlays on fixed assets and working capital, operating cash flow and terminal value.

But in a broader sense, there is only one type of cash flow that matters in capital budgeting analysis:

incremental cash flow. To rephrase the oath that witnesses take in television courtroom dramas, analysts

must focus on ‘all incremental cash flow and nothing but incremental cash flow’. Determining which

cash flows are incremental and which are not for a given project can become complicated at times.

LO10.3

When company managers are

evaluating a new investment

proposal, how do they try to

quantify potential reactions by

competitors and factor those into

their financial analysis?

thinking cap

question

finance in practice

THE VALUE OF AN MBA

You earn $60,000 per year working as an engineer

for a software developer, and you pay taxes at a

flat rate of 35%. You expect salary increases each

year of about 5%. Lately, you have been thinking

about going back to school to earn an MBA. A few

months ago, you spent $1,000 to enrol in a Graduate

Management Admission Test (GMAT) study course,

and $2,000 visiting various business schools. From

your research on MBA programs, you have learned

a great deal about the costs and benefits of the

degree. At the beginning of each of the next two

years, your out-of-pocket costs for tuition, fees and

textbooks will be $35,000. You expect to spend

roughly the same amount on room and board in

graduate school that you spend now. At the end of

two years, you anticipate that you will get an offer

for a job with a salary of $90,000, and you expect

that your pay will increase by 8% per year over your

career (spanning roughly the next 30 years). The

schedule of incremental cash flows for the next few

periods looks like this:

Year 0 –$35,000

Year 1 – 35,000

Year 2 +15,503

Year 3 +18,032

Observe that we did not include the $1,000

spent studying for the GMAT and the $2,000 spent

visiting MBA programs in the cash outflow for year

0. Those costs have already been incurred, and
   they cannot be recovered even if you decide not
   to get an MBA, so they are not incremental. The
   cash inflow figures for years 2 and 3 require some
   explanation. Had you stayed at your current job for
   the next two years, rather than gone back to school,
   your pay would have increased to $66,150 ($60,000
   × (1 + 0.05)^2 ). Therefore, the difference between that
   figure and your $90,000 post-MBA salary represents
   a net cash inflow of $23,850. Assuming that you pay
   about 35% of your earnings in taxes, the after-tax
   inflow would be $15,503 ($23,850 × (1.00 – 0.35)).
   In year 3, you expect to earn 8% more, or $97,200,
   compared with what you would have earned at your
   old job, $69,458 ($66,150 × (1 + 0.05)). The after-tax
   cash inflow in year 3 equals $18,032 (($97,200 –
   $69,458) × (1.00 – 0.35)). If you carry these steps out
   for 30 years, you will quickly see that the MBA has
   a substantial positive NPV at almost any reasonable
   discount rate.
   Obviously these assumptions are simplified,
   since it is unlikely that your tax rate will remain
   constant at 35%, or that your annual salary increases
   will occur at a constant rate.
   Review: Are there any other incremental cash
   flows that you should consider?

Paul Savastano, Director

of Information Technology,

Sprint Nextel Corp.

‘So the challenge

becomes, how do you

quantify the benefits

when a big piece of the

investment is going to

be for things that people

never see?’

See the entire interview on

the CourseMate website.

COUrSEMATE
SMArT VIDEO

Source: Cengage Learning