Identifying the Relevant Cash Flows 299
Noncash Charges In calculating net income, accountants usually subtract depreci-
ation from revenues. So, while accountants do not subtract the purchase price of fixed
assets when calculating accounting income, they do subtract a charge each year for de-
preciation. Depreciation shelters income from taxation, and this has an impact on cash
flow, but depreciation itself is not a cash flow. Therefore, depreciation must be added
to NOPAT when estimating a project’s cash flow.
Changes in Net Operating Working Capital Normally, additional inventories
are required to support a new operation, and expanded sales tie up additional funds in
accounts receivable. However, payables and accruals increase as a result of the expan-
sion, and this reduces the cash needed to finance inventories and receivables. The dif-
ference between the required increase in operating current assets and the increase in
operating current liabilities is the change in net operating working capital.If this
change is positive, as it generally is for expansion projects, then additional financing,
over and above the cost of the fixed assets, will be needed.
Toward the end of a project’s life, inventories will be used but not replaced, and re-
ceivables will be collected without corresponding replacements. As these changes oc-
cur, the firm will receive cash inflows, and as a result, the investment in net operating
working capital will be returned by the end of the project’s life.
Interest Expenses Are Not Included in Project Cash Flows Recall from Chap-
ter 7 that we discount a project’s cash flows by its cost of capital, and that the cost of
capital is a weighted average (WACC) of the costs of debt, preferred stock, and com-
mon equity, adjusted for the project’s risk. Moreover, the WACC is the rate of return
necessary to satisfy all of the firm’s investors—debtholders and stockholders. In other
words, the project generates cash flows that are available for all investors, and we find
the value of the project by discounting those cash flows at the average rate required by
all investors. Therefore, we do not subtract interest when estimating a project’s cash
flows.
If you did not take our advice and instead were to subtract interest (or interest plus
principal payments), then you would be calculating the cash flows available only for
equity investors, which should be discounted at the rate of return required by equity
investors. One problem with this approach, though, is that you must adjust the
amount of debt each year by exactly the right amount. If you were extremely careful
doing this, then you should get the correct result. However, this is a very complicated
process, and we do not recommend that you try it. Here is one final caution: If you did
subtract interest, you would definitely be wrong to discount that cash flow, which is
available only for equity holders, at the project’s WACC, since the project’s WACC is
the average rate expected by all investors, not just the equity investors.
Note that this differs from the procedures used to calculate accounting income.
Accountants measure the profit available for stockholders, so interest expenses are
subtracted. However, project cash flow is the cash flow available for all investors,
bondholders as well as stockholders, so interest expenses are not subtracted. This is
completely analogous to the procedures used in the corporate valuation model of
Chapter 12, where the company’s free cash flows are discounted at the WACC.There-
fore, you should not subtract interest expenses when finding a project’s cash flows.
Incremental Cash Flows
In evaluating a project, we focus on those cash flows that occur if and only if we accept
the project. These cash flows, called incremental cash flows,represent the change in
298 Cash Flow Estimation and Risk Analysis
