Introduction to Corporate Finance

10: Cash Flow and Capital Budgeting

that investors receive exactly what they require,
so the investment is just worth making, and its
NPV should be zero. Why does the calculation
above show a negative NPV? By deducting interest
expenses from cash flows and discounting cash
flows at a rate that also reflects the after-tax cost of
debt, the analyst’s NPV calculation double counts
that financing cost. If we ignore the project’s
financing cash flows and recalculate the NPV, it
becomes apparent that the investment indeed just
satisfies investors.

Sales $ 440,000

Operating expenses –300,000

Pre-tax cash flow $ 140,000

Taxes (30%) – 42,000

After-tax cash flow $ 98,000

NPV = –$1,000,000 + $98,000 ÷ 0.098 = $0

example

In an operational sense, when using the income statement to develop an investment’s relevant

cash flows, we ignore financing costs by focusing on earnings before interest rather than earnings after

deduction of interest expense. Given the structure of an income statement, earnings before interest also

excludes all dividends paid to preferred and/or ordinary shareholders. The deduction of interest expense

and dividends would double-charge the company for its financing costs – once in the cash flows and

again in the discount rate used to find present value. As we demonstrate later in this chapter, you should

ignore both interest and dividends when developing an investment’s relevant cash flows.

Considering Taxes

When determining cash flows, it is important to account for taxes paid to the government. Remember, we

evaluate a project from the perspective of the shareholder. Taxes reduce the cash flows that companies

can pay to their shareholders; therefore, when performing a capital budgeting analysis, all cash flows

should be measured on an after-tax basis.

In the previous example we demonstrated that interest expense and other financing cash flows should

be excluded from a project’s cash flow projections. Similarly, it is necessary to calculate the taxes that

a company must pay on an investment’s cash flows as if the company had no debt. In other words, the

after-tax cash flows used in capital budgeting are those for an all-equity project. The discount rate used

in the NPV calculation captures the effects of the tax break that companies receive when they use debt

financing, just as it accounts for the interest payments that companies make to bondholders.

The existence of different tax jurisdictions (local, state, national and international) means that

determining taxes paid can be somewhat complicated in practice. To keep you focused on the important

issues, in this chapter we use simplified illustrations to emphasise the principles involved in measuring

after-tax cash flows. To minimise distraction, throughout the chapter we assume that the corporate

income tax rate equals 30% (the current Australian corporate tax rate). However, bear in mind that

applicable tax rates can vary; for example, if the company is set up as a sole trader.

Another factor that you may need to consider (which we ignore in this chapter, but discuss in

Chapter 13, in section 13-3c, and Chapter 15, in sections 15-1a and 15-4a) is that Australia operates

under an imputation tax system. This means that if a company pays corporate tax, this is transferred

through to its dividends as franking credits. Shareholders can then offset these against their taxable

income. The rationale behind this is to remove any double taxation of income derived from investing