Tax Effects 301
A few young firms, including Dell Computer, have been successful selling their
products only over the Internet. Many firms, however, had established retail channels
long before the Internet became a reality. For these firms, the decision to begin selling
directly to consumers over the Internet is not a simple one. For example, Nautica En-
terprises Inc. is an international company that designs, sources, markets, and distrib-
utes sportswear. Nautica sells its products to traditional retailers such as Saks Fifth Av-
enue and Parisian, who then sell to consumers. If Nautica opens its own online
Internet store, it could potentially increase its profit margin by avoiding the substan-
tial markup added by dealers. However, Internet sales would probably cannibalize
sales through its retailer network. Even worse, retailers might react adversely to Nau-
tica’s Internet sales by redirecting the marketing effort and display space they now
provide Nautica to other brands that do not compete over the Internet. Nautica, and
many other producers, must determine whether the new profits from Internet sales
will compensate for lost profits from existing channels. Thus far, Nautica has decided
to stay with its traditional retailers.
Rather than focusing narrowly on the project at hand, analysts must anticipate the
project’s impact on the rest of the firm, which requires imagination and creative think-
ing. As the IBM and Nautica examples illustrate, it is critical to identify and account
for all externalities when evaluating a proposed project.
Timing of Cash Flow
We must account properly for the timing of cash flows. Accounting income state-
ments are for periods such as years or months, so they do not reflect exactly when dur-
ing the period cash revenues or expenses occur. Because of the time value of money,
capital budgeting cash flows should in theory be analyzed exactly as they occur. Of
course, there must be a compromise between accuracy and feasibility. A time line with
daily cash flows would in theory be most accurate, but daily cash flow estimates would
be costly to construct, unwieldy to use, and probably no more accurate than annual
cash flow estimates because we simply cannot forecast well enough to warrant this de-
gree of detail. Therefore, in most cases, we simply assume that all cash flows occur at
the end of every year. However, for some projects, it may be useful to assume that cash
flows occur at mid-year, or even quarterly or monthly.
Why should companies use project cash flow rather than accounting income
when finding the NPV of a project?
How do shipping and installation costs affect the depreciable basis?
What is the most common noncash charge that must be added back when find-
ing project cash flows?
What is net operating working capital, and how does it affect a project’s costs in
capital budgeting?
Explain the following terms: incremental cash flow, sunk cost, opportunity cost,
externality, and cannibalization.
Tax Effects
Taxes have a major effect on cash flows, and in many cases tax effects will make or
break a project. Therefore, it is critical that taxes be dealt with correctly. Our tax laws
are extremely complex, and they are subject to interpretation and to change. You can
300 Cash Flow Estimation and Risk Analysis
