Introduction to Corporate Finance

PArT 3: CAPITAL BUDGETING

in equities. Depending on individual shareholders’ circumstances, franking credits can have significant

value, and can therefore impact investment decisions.

Adjusting for Non-Cash Expenses

Although we have emphasised that managers must focus on the cash flows that an investment generates,

they cannot totally ignore non-cash expenses (tax-deductible expenses for which there is no corresponding

cash outflow in the current period) when projecting cash flows. Non-cash expenses, such as depreciation

or amortisation, affect an investment’s cash flows because they reduce the taxes that companies pay.

Remember, depreciation deductions reflect the accounting profession’s reliance on the accrual method

to portray a company’s financial condition. Therefore, when a company’s income statement shows a

deduction for depreciation, it does not mean that the company has actually incurred a cash charge for

depreciation. Nevertheless, the depreciation expense reduces income subject to government taxation,

and therefore it reduces the company’s tax bill. In other words, the depreciation deduction itself does not

represent a cash outflow, but it does produce a real cash flow by shielding some of the company’s cash

flows from taxes.

There are two ways to calculate cash flows that take this effect into account. First, we can add

non-cash expenses back to net income before interest and after taxes. Alternatively, we can ignore non-cash

expenses when calculating net income before interest and after taxes, and then add back the tax savings

created by non-cash deductions.

example

Let’s examine two ways to treat non-cash expenses

to obtain cash flow numbers for a simple project.

Suppose a company spends $30,000 in cash to

purchase a fixed asset today that it plans to fully

depreciate on a straight-line basis over three

years. After acquiring this machine, the company

can produce 10,000 units of some product each

year. Each unit costs $1 to make and sells for $3.

Given this information, we can construct an income

statement for this project. In each of the next three

years, the project income statement would look like

this (note that the $30,000 initial investment does

not appear here):

Sales $30,000

Less: Cost of goods 10,000

Gross profit $20,000

Less: Depreciation 10,000

Pre-tax income $10,000

Less: Taxes (30%) 3,000

Net income after taxes $ 7,000

After the company spends $30,000 to make this

investment, how much cash flow will it generate in

each of the subsequent three years? There are two

ways to arrive at the answer.

example

First, take net income after taxes and add back depreciation, for which there was no cash outlay:

Cash flow = Net income after taxes + Depreciation

= $7,000 + $10,000 + $17,000

Second, calculate net income after taxes, ignoring depreciation expense, then add back the tax savings

generated by the depreciation deduction:

non-cash expenses
Tax-deductible expenses
for which there is no
corresponding cash outflow
in the current period. They
include depreciation and
amortisation