Introduction to Corporate Finance

PArT 3: CAPITAL BUDGETING

10-3c YEAr 2 CASH FLOW

In year 2 we simply repeat the steps we followed to arrive at year 1’s cash flow numbers. Net income

equals $10,010. To that, add back the $10,000 non-cash depreciation deduction. Next, determine the

change in working capital. The working capital balance increased from $10,283 in year 1 to $20,905 in

year 2, so this represents a cash outflow of $10,622. As in year 1, there are no new investments in fixed

assets to consider, so the net cash flow in year 2 equals:

Net income $ 10,010

Depreciation 10,000

Increase in working capital –10,622

Net cash flow $ 9,388

Table 10.4 illustrates the annual net cash flows for the investment project all the way through to

the end of the sixth year. Several interesting patterns emerge from this table. First, the project’s cash

flows grow rapidly for the first five years, primarily because sales volume is growing. However, notice

that in year 6, two interesting things happen. First, tax savings from depreciation deductions run out, so

an important source of cash inflows stops. Second, the change in working capital in year 6 is relatively

small compared to the other years. Remember that the thing driving Protect IT to invest in more working

capital each year was sales growth. By year 6, sales growth has slowed to the long-run rate of 4%, so the

company doesn’t need to increase working capital items as fast as it had in the project’s first five years.

TABLE 10.4 ANNUAL NET CASH FLOW ESTIMATES FOR PROTECT IT’S INVESTMENT PROJECT

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6

New fixed

assets

$50,000 $ 0 $ 0 $ 0 $ 0 $ 0 $ 0

Change in

working capital

–$ 3,000a –$ 7,282 –$10,623 –$11,543 –$11,243 –$ 3,781 –$ 2,041

Net income $ 0 $ 655 $10,010 $20,216 $30,422 $33,824 $42,525

Depreciation $ 0 $10,000 $10,000 $10,000 $10,000 $10,000 $ 0

Net cash flow –$53,000 $ 3,372 $ 9,387 $18,673 $29,179 $40,043 $40,485

a Represents the initial working capital investment.

Because this project starts generating net cash inflows as early as year 1, it is probably not

representative of most investment projects that companies undertake. Many projects, especially those

that involve launching new ventures or product lines, take several years before they produce positive cash

flow. If Protect IT discounts the project’s cash flows at 15%, it has a positive NPV of $23,403, counting

only the first six years’ cash flows. But that probably understates the investment’s true value because

Protect IT will surely operate this business beyond year 6. Therefore, to complete the analysis, we need

to estimate this venture’s terminal value.

10-3d TErMINAL VALUE

We produce two different terminal-value estimates for this project. In the first, we assume that by year

6 the project has reached a steady state, meaning that cash flows will grow at 4% per year indefinitely.

In the second, we assume that the company sells its investment at the end of year 6 and receives a cash

payment equal to the project’s book value.