Free Cash Flow Valuation 185Sunk Costs
Some expenses related to the project may be incurred before the investment analysis is considered. For
instance, the sponsors of Cochin Airport might have hired a consultant to assess the viability of an airport
and spent some money on the feasibility study. Such expenses are called sunk costs. Since sunk costs cannot
be recovered if the project is rejected, they have to be ignored. Thus, the money spent on research and devel-
opment should be ignored. Then who should pay for sunk costs? The cumulative NPV of all successful
projects should cover the sunk costs of all projects undertaken.
Working Capital Investment
Apart from investment in fixed assets, a firm will have to invest in current assets like inventory and book
debts for day-to-day running of the business. Part of current assets can be funded by non-interest bearing
current liabilities like accounts payable, and salaries and wages payable. The excess of current assets over
current liabilities, which is to be funded by other sources, is called net working capital. Often, executives
either ignore or understate working capital investment. The new project causes sales to rise which leads to
higher accounts receivable and inventory; the NPV is overstated. Usually the spontaneous rise in accounts
payable and other accrued liabilities will not cover the increase in current assets. The gap comes from new
debt, which increases risk. Executives usually do not notice this. Many projects end up with substantial cost
over runs. As a rough estimate working capital can be expressed as a function of the level of activity, i.e., num-
ber of units sold or sales revenue. To illustrate, working capital for a project may be 15 percent of revenues.
Impact of Depreciation
Cash flow = EBIT – Tax on EBIT + Depreciation – Capital expenditure- (+) increase (decrease) in working capital
NPV is a function of cash flows and cash flow is a function of depreciation. The higher the depreciation, the
higher is the cash flow and hence NPV—other things remaining constant.
Assume the following data:
Initial investment = Rs 4500
Project life = 4 years
Salvage value = 0
Discount rate = 15 percent1 234EBIT 1,000 2,000 3,000 4,000
- Tax @ 35 percent 350 700 1,050 1,400
- Depreciation 1,125 1,125 1,125 1,125
Cash flow 1,775 2,425 3,025 3,725
NPV = – 4500 + PV of cash flows = Rs 2,998.70If the method of depreciation were to be changed: