FREE online courses on Capital Budgeting Analysis - Calculating the
Discounted Cash Flows - Discounted Cash Flows
In capital budgeting analysis we want to determine the after
tax cash flows associated with capital projects. We are concerned with all
relevant changes or differences to cash flows once we invest in the project.
Understanding “Relevancy”
One question that we must ask in capital budgeting is what is
relevant. Here are some examples of what is relevant to project cash flows:
Capital assets are subject to depreciation and we need to
account for depreciation twice in our calculations of cash flows. We deduct
depreciation once to calculate the taxes we pay on project revenues and we add
back depreciation to arrive at cash flows because depreciation is a non-cash
item.
Major investments may require increases to working capital.
For example, new production facilities often require more inventories and higher
salaries payable. Therefore, we need to consider the net change in working
capital associated with our project. Changes in net working capital will
sometimes reverse themselves at the end of the project.
Many capital projects can result in increases to allocated
overheads, such as computer support services. However, the subjective nature of
overhead allocations may not make any difference at all. Therefore, you need to
assess the impact of your capital project on overhead and determine if these
costs are relevant.
If we plan on financing a capital project, this will involve
additional cash flows to investors. The best way to account for financing costs
is to include them within our discount rate. This eliminates the possibility of
double-counting the financing costs by deducting them in our cash flows and
discounting at our cost of capital which also includes our financing costs.
We also need to ignore costs that are sunk; i.e. costs that
will not change if we invest in the project. For example, a new product line may
require some preliminary marketing research. This research is done regardless of
the project and thus, it is sunk. The concept of sunk costs and relevant costs
applies to all types of financing decisions.
