Ross et al.: Fundamentals
of Corporate Finance, Sixth
Edition, Alternate EditionIV. Capital Budgeting 10. Making Capital
Investment Decisions(^348) © The McGraw−Hill
Companies, 2002
MORE ON PROJECT CASH FLOW
In this section, we take a closer look at some aspects of project cash flow. In particular,
we discuss project net working capital in more detail. We then examine current tax laws
regarding depreciation. Finally, we work through a more involved example of the capi-
tal investment decision.
A Closer Look at Net Working Capital
In calculating operating cash flow, we did not explicitly consider the fact that some of
our sales might be on credit. Also, we may not have actually paid some of the costs
shown. In either case, the cash flow in question would not yet have occurred. We show
here that these possibilities are not a problem as long as we don’t forget to include
changes in net working capital in our analysis. This discussion thus emphasizes the im-
portance and the effect of doing so.
Suppose that during a particular year of a project we have the following simplified
income statement:
Depreciation and taxes are zero. No fixed assets are purchased during the year. Also, to
illustrate a point, we assume that the only components of net working capital are ac-
counts receivable and payable. The beginning and ending amounts for these accounts
are as follows:
Based on this information, what is total cash flow for the year? We can first just me-
chanically apply what we have been discussing to come up with the answer. Operating
cash flow in this particular case is the same as EBIT because there are no taxes or
depreciation and thus it equals $190. Also, notice that net working capital actually
declinedby $25. This just means that $25 was freed up during the year. There was no
capital spending, so the total cash flow for the year is:
Total cash flow Operating cash flow Change in NWC Capital spending
$190 (25) 0
$215
CONCEPT QUESTIONS
10.3a What is the definition of project operating cash flow? How does this differ from
net income?
10.3bFor the shark attractant project, why did we add back the firm’s net working
capital investment in the final year?
CHAPTER 10 Making Capital Investment Decisions 319
10.4
Sales $500
Costs 310
Net income $190Beginning of Year End of Year Change
Accounts receivable $880 $910 $30
Accounts payable 550 605 55
Net working capital $330 $305 $25