The document provides an overview of key concepts for financial managers regarding capital budgeting. It discusses: 1) The goals of financial managers to maximize shareholder value by selecting projects with positive net present value (NPV). NPV measures the incremental cash flows of projects discounted at the cost of capital. 2) The distinction between accounting profits and cash flows that are relevant for capital budgeting. Cash flows consider the timing of cash inflows and outflows while accounting adjusts for accruals. 3) The concept of incremental cash flows which are the difference in cash flows from undertaking a project versus not undertaking it. Only incremental cash flows are considered in the analysis. 4) A detailed example is

1. Frank S. Skinner, Brunel University

2. Overview of Lecture
Goals of the Finance Manager
Cash flows vs Accounting data
Incremental Cash Flows
Detailed example
Inflation
Abandonment Problem
2

3. Goals of the financial manager
 The manager is an agent of the investors of the firm.
Therefore the manager should be concerned with
satisfying the demands of these investors.
 What do investor’s want?
 How can you make decisions as to what project to
accept so all investors will agree with you? Capital
budgeting answers this question.
 The NPV method measures the amount by which the
value of the firm will increase upon acceptance of the
project
 The general principal is that we measure incremental,
after tax, cash flows.

4. Cash Flows
 While accountants focus on net income,
shareholders would be more interested in net cash
flows.
 These two are not the same, because of the
presence of non-cash revenues and expenses.
 To appreciate why we make this distinction, consider
the tasks of finance and then consider the tasks of
accounting.
4

5. Accounting vs Finance Data
 Finance measures cash flows….
Cash out (+)
Cash in (-)
We want to account for the timing of these cash
flows as we want to account for the time value of
money

6. Accounting vs Finance Data
 Accounting measures periodic performance….
Cash out (+)
Cash in (-)
Difficult to work out how well the firm is doing.
- - +
+ +

7. Accounting vs Finance Data
 Accounting adjusts cash flows….
Cash out (+)
Cash in (-)
We want to measure periodic performance so we
allocate cash flows to the period upon which they
produce a benefit: this is the essence of accrual
accounting

8. As a practical matter..
 We get our information from the accounting
information system
 Therefore we adjust accounting information by adding
back non-cash expenses, typically we add back
depreciation.
 However, please note we do initially work with
depreciation because depreciation is an expense for tax
purposes.
 Therefore we work out the deprecation expense, then
deduct for taxes, and then add back depreciation to the
after tax cash flows.

9. Incremental Cash Flows
 The general principle is simple: A relevant cash flow
for a project changes the firm’s future cash flow.
 As relevant cash flows are defined in terms of
changes, or increments to the firm’s existing cash flow,
they are called incremental cash flows.
 Thus incremental cash flows is the difference
between a firm’s future cash flows with a project and
those without a project.

10. Stand alone Principle
 It would be difficult to calculate the future
total cash flows to the firm with or without a
project
 We need to focus only on the project’s
resulting incremental cash flow. This is called
stand alone principle.
 We shall be interested in comparing the cash
flows from this mini firm with the cost of
acquiring it.
 Advantage: Evaluating the proposed project
purely on its own merits.

11. Sunk Costs
• A sunk cost is a cost we have already paid.
• Such a cost can not be changed by the decision today
to accept or reject a project. It is not incremental.
• Such a cost is not relevant to the decision at hand.
• For example: A company employed a consultant to
provide advice. Now we are to decide whether to
accept the project or not. The fee is a sunk cost: it
had been paid and does not depend on whether the
project is actually launched or not.

12. Opportunity Costs
• An opportunity cost requires us to give up a benefit.
• So opportunity costs are incremental.
• A common situation arises in which a firm already owns
some of the assets a proposed project will be using.
• Opportunity Cost Definition: The most valuable
alternative use of an asset is the measure of its
opportunity cost.

13. Opportunity Costs: Example
• Suppose we plan to convert an old cotton mill into
apartments. We bought the mill years ago for £100,000.
• If we undertake this project, there will be no direct cash
outflow associated with buying the old mill, because we
already own it. So at first it does not look incremental.
• But using the mill for the apartment complex has an
opportunity cost because we give up the valuable
opportunity to do something else with the mill. Suppose the
best alternate use is to sell it.
• The fact that we paid £100,000 is a sunk cost and not
relevant.
• The opportunity cost that we charge the project is what the
mill would sell for today because this this is the amount we
give up by using the mill instead of selling it.

14. Another example
• A proposal to make a newly-developed product offers an
NPV of £3m.
• An alternative is for the firm to sell the patent for £4m
to another firm for it to make the product.
• NPV £3m
• Opportunity cost £4m
• NPV -£1m

15. Side effects
• Incremental cash flows for a project include all the
resulting changes in the firm’s future cash flows.
• It would not be unusual for a project to have a side
effect or spill over effects both good and bad.

16. Side effects (Example)
• i.e. in 2010 the time between release of a film and the
release of the DVD had shrunk to 98 days, compared
with 200 days 10 years earlier.
• This shortened release is blamed for at least part of the
decline in average movie Theatre Box Office revenue.
• This is an example of erosion, a negative side effect.
• Retailers cheered the move, because it was credited
with increasing DVD sales.
• This is an example of a positive spillover.
• So the decision to change the timing of DVD sales
needs to consider both the negative and positive side
effects.

17. Erosion
• Negative impact on the cash flow of an
existing product from the introduction of a
new product is called erosion.
• EXAMPLE: One of the Walt Disney Company’s
concern when it build Euro Disney was that
the new park would drain visitors from the
Florida park.
• Presumes the firm has some degree of
monopoly power.

18. Spill over effects (Example)
• Hewlett Packard was not too bothered when the
price of a printer that sold for £500 - £600 in 1994
declined approximately £70 in 2012.
• This is not surprising once you consider the positive
spill over.
• HP realised that the big money was in the
consumables that printer owners buy to keep their
printers running, such as inkjet cartridges and special
paper.

19. Financing Costs
• In analysing a proposed investment we shall not include
interest paid or any other financing costs such as
dividends or principal paid in the cash flows of the
project, even though these are incremental cash flows.
• This is because we account for the cost of capital, which
includes interest payments and dividends, in the
discount rate we used to find the NPV of the project.

20. Detailed example of how to calculate NPV
 The general principal is that we measure incremental,
after tax, cash flows.
 Building and land that we purchased a few years ago
for a total of £120,000.
 Now has a market value of £90,000 for the building
and £50,000 for the land.
 Net of depreciation the book value of the building is
now £100,000 and is depreciated at a 10% declining
balance rate.
 In 10 years, the value of the land and the building is
estimated to be £75,000 and £70,000 respectively.

21. Example continued
 -Price of widgets £12, expected sales 20,000 per year.
 -Widget machine cost £200,000, useful life is 10 years, salvage
value of £30,000 after 10 years.
 -Tax: Flat income tax of 40% (no capital gains tax), investment
subsidy on machinery of 10% of capital cost, tax depreciation on
machine is at a 25% and on building at a 10% declining balance
rate.
 -Per Widget cost breakdown
 (From Cost Accountants)-Labour £6.00
-Materials 3.00
-Accounting Depreciation 1.00
-allocation of fixed overhead 2.00
-Interest expense 1.00
Total £13.00
 -New Working capital £50,000
 -Cost of capital 10%

22. The five steps of the NPV method
1. Estimate the incremental investment
 opportunity costs of resources used
 payment and installation cost of new equipment
 salvage value of old equipment
 tax effects e.g. investment subsidies
 changes in the level of Net Working Capital
2. Determine intermediate net incremental after tax
cash flows

23. Steps 3 to 5
3) Estimate end of project cash flows
 salvage values
 return of working capital
 terminal costs e.g. environmental cleanup,
severance pay, pension costs
4) discount the incremental after tax cash flows of
steps 2 and 3 (and 1 too, if applicable) to the
present time using the opportunity cost of capital
5) determine the NPV

24. Example
CC 0.1
Year 0 1 2 3 4 5 6 7 8 9 10
Sales 20000 20000 20000 20000 20000 20000 20000 20000 20000 20000
Land -50000 75000
Building -90000 70000
Machine -200000 30000
Subsidy 20000
Working capital -50000 50000
Gross Revenue 60000 60000 60000 60000 60000 60000 60000 60000 60000 60000
Depreciation:
Machine
45000 33750 25313 18984 14238 10679 8009 6007 4505 -16485
Depreciation:
Building
10000 9000 8100 7290 6561 5905 5314 4783 4305 -31258
BT Income 5000 17250 26588 33726 39201 43416 46677 49210 51190 107743
AT Income 3000 10350 15953 20235 23520 26050 28006 29526 30714 64646
Add Back
Depreciation
55000 42750 33413 26274 20799 16584 13323 10790 8810 -47743
ATCF -370000 58000 53100 49365 46510 44320 42633 41329 40316 39524 241903
PV -370000 52727 43884 37089 31767 27519 24065 21209 18808 16762 93264
NPV -2906
IRR 0.09844

25. Declining balance depreciation
Depreciation: Building
Beginning DBD Ending Balance
1 100000 10000 90000
2 90000 9000 81000
3 81000 8100 72900
4 72900 7290 65610
5 65610 6561 59049
6 59049 5905 53144
7 53144 5314 47830
8 47830 4783 43047
9 43047 4305 38742
10 38742 3874 34868
Terminal Depreciation = beginning terminal balance less
salvage value
-31,258 = 38,742 – 70,000

26. Declining balance depreciation
Depreciation: Machine
Beginning DBD Ending Balance
1 180000 45000 135000
2 135000 33750 101250
3 101250 25313 75938
4 75938 18984 56953
5 56953 14238 42715
6 42715 10679 32036
7 32036 8009 24027
8 24027 6007 18020
9 18020 4505 13515
10 13515 3379 10136
Terminal Depreciation = beginning terminal balance
less salvage value
-16485 = 13,515 – 30,000

27. Making sense of NPV
 What does this -£2,906 mean?
 It means that according to your analysis this project
will decrease the value of your firm by £2,906 . This
happens because the project is estimated to provide
a return that is less than the cost of capital. NPV
operationalizes the goal of maximising the value of
the firm.
 How comfortable are you with this analysis?
 What do you see as the potential problems?
 Assumptions: Sensitivity Analysis or Scenario
Analysis (Consistency of assumptions) Next topic

28. What is the IRR of this project?
 IRR = 9.844% (Accept or reject?)
 How to find? Trial and error.
 Since IRR < Cost of Capital, you reject
 Rationale: if IRR < Cost of Capital, then the
project’s rate of return is less than its cost.
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29. Interest rate
NPV
NPV =0
Interest rate = IRR
Plotting the NPV against
changing interest rates
Note the inverse relation between the interest rate and value

30. A note on inflation
 To deal with inflation, there is a general rule.
 Discount nominal cash flows with a nominal discount rate
 Or discount real cash flows with a real discount rate.
 So which would you prefer to adjust, the discount
rate or the cash flows?
 Note that by default, the cost of capital will
automatically include the impact of inflation.

31. Adjust discount rate for inflation
 Discount rates already include an inflation
premium.
 Therefore do not adjust cash flows for inflation,
but reduce the discount rate by the rate of
inflation.
 We need to work out the size of the inflation
premium that is already included in the discount
rate and take it out of the discount rate.
 But small errors can lead to large changes in the
NPV.

32. Adjust cash flows for inflation
 More work since you need to increase all the future
cash flows for inflation. (Leave the discount rate
alone)
 But information revealed maybe valuable.
 For instance, you may find out that revenues may be
projected to increase by less than the rate of
inflation, while material costs maybe projected to
increase at a rate greater than the rate of inflation.
This would suggest that you look at re-engineering
your product rather than abandoning it.

33. Abandonment problem
 For any number of reasons the sale value or
abandonment value of a project maybe greater than
the PV of continued use by the firm.
 Take the example of a supermarket.
 At any point in time you always have two choices,
1. continue to operate the supermarket and thereby gain
supermarket cash flows
2. abandon the supermarket and get the abandonment
value (sell the supermarket site).
 Once PV of 2 > PV of 1, do you immediately abandon?