Capital Budgeting: Calculating Cash Flows and Valuation Metrics

Investment Analysis II: Key Cash Flow Components

Financial leverage is debt. "Unleveraged" Free Cash Flow (FCF) means we calculate FCF without regard to how the firm is financed. Ultimately, we are valuing the assets of the project. We achieve this by estimating how much cash is generated by the asset side of the balance sheet.

Capital Expenditure (CAPEX)

Capital Expenditure (CAPEX) is defined as the original cost of investment in property, plant, or equipment and other long-term assets.

Formula for CAPEX

NET PPE (current) - NET PPE (prior) + Depreciation

Depreciation and Asset Valuation

Depreciation: Depreciation charges are intended to represent the cost of wear and tear over the asset's life. The Straight-Line Depreciation method divides the asset’s cost equally over its useful life.

Depreciation and Salvage Value Formulas

• Book Value = CAPEX (Initial cost) − Accumulated Depreciation
• After-Tax Salvage = Salvage − Tax Rate × (Salvage − Book Value)

Tax implications related to Salvage Value and Book Value:

• If the Salvage Value is less than the Recorded Book Value, you pay tax.
• If the Salvage Value is greater than the Recorded Book Value, you do not pay tax.
• If the Salvage Value equals the Recorded Book Value, there is no tax payable or received.

Changes in Net Working Capital (NWC)

Net Working Capital (NWC) = Non-cash Current Assets − Non-debt Current Liabilities

Components of Net Working Capital

Non-Cash Current Assets

Assets not held on a continuing basis; expected to be consumed or converted into cash within one operating cycle. Examples include Inventory and Accounts Receivable.

Non-Debt Current Liabilities

Liabilities payable to outside parties within one operating cycle (e.g., Accounts Payable).

Operating Cash Flow (OCF) Calculation

1. The Top-Down Approach

A project’s Operating Cash Flow (OCF) can be calculated directly using the following shorthand formula:

OCF = (Rev − VC − FC − Dep) × (1 − Tax) + Dep

Where:

• Rev: Revenue
• VC: Variable Costs
• FC: Fixed Costs
• Dep: Depreciation

2. The Tax Shield Approach

Since the only effect of depreciation is to reduce the firm’s taxable income, we can rewrite the above equation:

OCF = (Rev − VC − FC) × (1 − Tax) + (Dep × Tax)

The term (Dep × Tax) represents the Depreciation Tax Shield: the tax savings that result from the ability to deduct depreciation when calculating taxable income.

Cash Flow Considerations for Project Valuation

When calculating cash flows, remember the following rules:

• Do not include sunk costs.
• Do include loss of sales due to new products being introduced (erosion).
• Opportunity costs must all be included.

How Firms Utilize Free Cash Flow (FCF)

What does the firm do with its FCF? First, it makes interest payments to its bondholders because common shareholders are paid after all creditors. The amount left over may be paid out to shareholders in the form of dividends, reinvested back into the business, or put the rest in the bank to save for the next year.

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