Principles of Corporate Finance_ 12th Edition

bre44380_ch06_132-161.indd 133 09/30/15 12:46 PM

Chapter 6 Making Investment Decisions with the Net Present Value Rule 133

Expenditures on intangible assets such as IT and R&D are investments just like expen-
ditures on new plant and equipment. In each case the company is spending money today in
the expectation that it will generate a stream of future profits. Ideally, firms should apply the
same criteria to all capital investments, regardless of whether they involve a tangible or intan-
gible asset.
We have seen that an investment in any asset creates wealth if the discounted value of the
future cash flows exceeds the up-front cost. But up to this point we have glossed over the
problem of what to discount. When you are faced with this problem, you should stick to four
general rules:

1. Only cash flow is relevant.


2. Always estimate cash flows on an incremental basis.


3. Be consistent in your treatment of inflation.


4. Separate investment and financing decisions.

We discuss each of these rules in turn.

Rule 1: Only Cash Flow Is Relevant

The first and most important point: Net present value depends on future cash flow. Cash flow
is simply the difference between cash received and cash paid out. Many people nevertheless
confuse cash flow with accounting income. Accounting income is intended to show how well
the company is performing. Therefore, accountants start with “dollars in” and “dollars out,”
but to obtain accounting income they adjust these inputs in two principal ways.

Capital Expenses When calculating expenditures, the accountant deducts current expenses
but does not deduct capital expenses. There is a good reason for this. If the firm lays out a
large amount of money on a big capital project, you do not conclude that the firm is perform-
ing poorly, even though a lot of cash is going out the door. Therefore, instead of deducting
capital expenditure as it occurs, the accountant depreciates the outlay over several years.
That makes sense when judging firm performance, but it will get you into trouble when
working out net present value. For example, suppose that you are analyzing an investment
proposal. It costs $2,000 and is expected to provide a cash flow of $1,500 in the first year and
$500 in the second. If the capital expenditure is depreciated over the two years, accounting
income is $500 in year 1 and – $500 in year 2:

Suppose you were given this forecast income and naïvely discounted it at 10%. NPV would
appear positive:

Apparent NPV =

$500

_____

1.10

+

−$500

______

1.10^2

= $ 41.32

This has to be nonsense. The project is obviously a loser. You are laying out $2,000 today
and simply getting it back later. At any positive discount rate the project has a negative NPV.
The message is clear: When calculating NPV, state capital expenditures when they occur, not
later when they show up as depreciation. To go from accounting income to cash flow, you

Year 1 Year 2

Cash inflow +$1,500 +$ 500

Less depreciation – 1,000 – 1,000

Accounting income +$ 500 – $ 500