Introduction to Corporate Finance

10: Cash Flow and Capital Budgeting

SUMMArY

■ To estimate an investment’s relevant cash

flows, the analyst focuses on incremental

cash flows, ignores financing costs, considers

taxes and adjusts for any non-cash expenses,

such as depreciation.

■ The costs of financing an investment, such as

interest paid to lenders and dividends paid

to shareholders, should not be counted as

part of a project’s cash outflows. In contrast,

these are included in the calculation of

accounting profit.

■ The discount rate captures the financing

costs, so deducting interest expense and

dividends from a project’s cash flows would

be double counting.

■ Certain types of cash flow are common to

many different kinds of investments. These

include fixed asset cash flow, working

capital cash flow, operating cash flow and

terminal cash flow.

■ Depreciation and amortisation are non-cash

items, so they should be excluded from the

calculation of cash flow. However, they have

an impact on taxes, which are calculated

on profits that do take into consideration

depreciation and amortisation. Tax payments

are included in cash flow calculations, which

should be measured on an after-tax basis for

capital budgeting purposes.

■ Only the incremental cash flows associated with

a project should be included in NPV analysis.

The analyst should avoid including sunk costs

in estimates of incremental cash flows.

■ Opportunity costs and any cannibalisation

should be reflected in an investment’s cash

flow projections.

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24% said they would make a moderate sacrifice

and 2% said they would make a large sacrifice to

smooth reported profits. This clearly suggests that

many managers will forgo positive-NPV investment

opportunities so as not to disrupt reported earnings

per share.

The most important financial measures reported by

managers to outsiders

Free cash

flows

10%

Pro forma

earnings

12%

Other

3%

Earnings

51%

Revenues

12%

Cash flows

from

operations

12%

Source: Reprinted from John R. Graham, Campbell R. Harvey and Shiva Rajgopal, ‘The Economic Implications of Corporate Financial Reporting,’

Journal of Accounting and Economics, 40 (2005), pp. 3–73, Figure 2 and Table 9, with permission from Elsevier.

LO 10.1

LO 10.2

LO 10.3