184 Corporate Finance
ACCEPTED PRINCIPLES
Estimation of project cash flows involves some generally accepted principles.
After Tax Incremental Cash Flows
The first principle in investment analysis is to consider only incremental cash flows. The idea is to arrive at
cash flows, either inflows or outflows, which can be traced to the project. To arrive at incremental cash flows
subtract the expected cash flows without the project from the expected cash flows with the project. Thus, if
you are evaluating two alternatives, subtract the cash flows from one alternative from the cash flows of the
second alternative to arrive at incremental cash flows. The NPV of the incremental cash flows should be
positive for the project to be accepted.
Income tax should be computed by applying the expected tax rate for each period to the taxable income,
excluding interest charges, of that period and all projects should be compared on the basis of after tax cash
flows and NPV. The tax rate used is the marginal tax rate applicable for the next rupee of earnings. The
depreciation for the purpose of reporting taxable income is calculated on the written down value method,
although the straight-line method may be used for accounting purposes. It is likely that in the initial years a
firm may incur losses and not absorb depreciation. The unabsorbed depreciation and losses may be carried
forward and set off in later years.
Opportunity Cost
In many cases, some of the resources, including human, needed for a project may be a part of the already
existing business. Such resources have alternative uses. These alternative uses create opportunity cost—the
cost for the existing business due to the new project. For instance, some executives may be transferred to
render analytical support to a project or the project may make use of already owned building. Are these
resources cost free? Obviously they are not free. The project has to be charged for these. Assume that a com-
pany has transferred some executives to the new project temporarily. These executives have to be replaced
by suitable personnel and incur an additional salary expenditure of Rs 13.5 lac. The opportunity cost for this
resource is Rs 13.5 lac. Similarly cost may be attached to other resources like buildings, plant and equipment,
vehicles, etc. based on the next best use or expenses incurred. The opportunity cost charged should measure
net cash flows that could have been earned had the project under consideration not been undertaken. In real
life situations it may be difficult to attach opportunity cost to all resources especially those that do not have
an alternative use.
An example is in order: A project under consideration will use an already owned office space in a com-
mercial complex for 4 years. The office could be let out for an annual rent of Rs 125,000 and the depreciation
tax shield lost per year is Rs 1,400. Assume a discount rate of 15 percent.
Opportunity cost = PV of rent forgone + PV of tax-shield lost
= Rs [125000 × PVIFA (15,4) + 1400 × PVIFA (15,4)
= Rs 360872Note that the depreciation tax shield is simply depreciation expense per year multiplied by tax rate. The
opportunity cost should be added to the initial investment.