CP

298 CHAPTER 8 Cash Flow Estimation and Risk Analysis

Identifying the Relevant Cash Flows

The first step in capital budgeting is to identify the relevant cash flows,defined as

the specific set of cash flows that should be considered in the decision at hand. Ana-

lysts often make errors in estimating cash flows, but two cardinal rules can help you

minimize mistakes: (1) Capital budgeting decisions must be based on cash flows,not ac-

counting income. (2) Only incremental cash flowsare relevant.

Free cash flowis the cash flow available for distribution to investors. In a nutshell,

the relevant cash flow for a project is the additionalfree cash flow that the company can

expect if it implements the project. It is the cash flow above and beyond what the com-

pany could expect if it doesn’t implement the project. The following sections discuss

the relevant cash flows in more detail.

Project Cash Flow versus Accounting Income

Free cash flow is calculated as follows:^1

Just as a firm’s value depends on its free cash flows, so does the value of a project. We

illustrate the estimation of project cash flow later in the chapter with a comprehensive

example, but it is important for you to understand that project cash flow differs from

accounting income.

Costs of Fixed Assets Most projects require assets, and asset purchases represent

negative cash flows. Even though the acquisition of assets results in a cash outflow, ac-

countants do not show the purchase of fixed assets as a deduction from accounting in-

come. Instead, they deduct a depreciation expense each year throughout the life of the

asset.

Note that the full cost of fixed assets includes any shipping and installation

costs. When a firm acquires fixed assets, it often must incur substantial costs for

shipping and installing the equipment. These charges are added to the price of the

equipment when the project’s cost is being determined. Then, the full cost of the

equipment, including shipping and installation costs, is used as thedepreciable

basiswhen depreciation charges are being calculated. For example, if a company

bought a computer with an invoice price of $100,000 and paid another $10,000 for

shipping and installation, then the full cost of the computer (and its depreciable

basis) would be $110,000. Note too that fixed assets can often be sold at the end

of a project’s life. If this is the case, then the after-tax cash proceeds represent a

positive cash flow. We will illustrate both depreciation and cash flow from asset

sales later in the chapter.

EBIT(1T) Depreciation 

Gross fixed asset

expenditures^

 c

 Operating current assets 

 Operating current liabilities

d.

Free cash flow

Net operating

profit after taxes

(NOPAT)

Depreciation

Gross fixed asset

expenditures



Change in net

operating

working capital

(^1) Chapter 9 explains the calculation of free cash flow. Note that EBIT stands for earnings before interest and
taxes, and it is also called pre-tax operating profit.

Cash Flow Estimation and Risk Analysis 297