Chapter 10
• Relevant Cash Flows and Stand-Alone Principle
Relevant cash flows = Changes in total firm cash flows caused by the project.
Incremental cash flows = Future cash flows with project – Future cash flows without project.
Ignore cash flows that happen regardless of the project.
Stand-alone principle = Evaluate a project as if it were a separate “mini-firm.”
For project decisions, we care about actual cash that the project brings in.
• Incremental Cash Flows
Sunk Costs:
Already spent and incurred, so it’s irrelevant.
Opportunity Costs:
Value of best alternative forgone, so it’s relevant.
• Side Effects:
Projects can have side effects, or spillover effects, which can be either positive or negative.
Erosion (negative spillover) If a company of soda drinks introduces a new diet soda
flavor, some people who used to buy their original one might switch to the new flavor.
The new flavor "erodes" the sales of the old one.
Positive spillover A company might open a new store in a location that increases foot
traffic to their other nearby stores.
We always take the project if IRR>RR unless it’s for financing, then we don’t take the project.
Kristina El Haddad, Spring 25
• Net Working Capital (NWC):
Projects usually require an investment in NWC (inventory, or receivables).
Treated like a loan: Money invested at the start and recovered at the end.
• Financing Costs:
Ignore financing (interest, or dividends) when evaluating projects.
We only care about the cash flows generated by the assets.
Project evaluation focuses only on operating cash flows.
• After-Tax Cash Flows:
Always work with after-tax cash flows.
• Pro Forma Financial Statements
Pro forma financial statements are projected numbers, not real historical ones.
“If we do this project, here’s what sales, costs, and profits should look like.”
We need to know if a project is worth it before spending money.
That’s why we build the project as if it were a mini firm alone, which is the Stand-Alone Principle.
à A Projected Income Statement:
Forecasts sales, costs, EBIT, and net income.
à A Projected Cash Flow Statement:
Forecasts how much real cash the project will generate.
Kristina El Haddad, Spring 25
Example:
Imagine you want to open a new coffee shop.
You build a mini “pro forma”
You don’t mix it with your current full-time job salary expenses.
➔ Only new cash flows caused by the coffee shop itself.
➔ Same exact idea in capital investment decisions.
Sell 50,000 units per year
Price = $4/unit
Variable cost = $2.50/unit
Fixed costs = $17,430/year
Initial investment (machine) = $90,000 (depreciated straight-line 3 years)
Net working capital needed = $20,000
Tax rate = 21%
Machine salvage value = $0
Building the Projected Income Statement
Line Calculation Amount
Sales 50,000 × $4 $200,000
Variable Costs 50,000 × $2.5 $125,000
Fixed $17,430
Depreciation $90,000/ 3 years $30,000
EBIT Sales –(V+F)– Dep $27,570
Taxes (21%) EBIT × 21% $5,790
Net Income EBIT – Taxes $21,780
Capital Spending and Working Capital:
Kristina El Haddad, Spring 25
Initial Cash Outflows:
Machine purchase = $90,000
Net Working Capital = $20,000
Yearly Cash Flows:
Get $51,780 operating cash flow
End of project (Year 3):
Recover $20,000 working capital.
• Operating Cash Flow (OCF)
OCF = EBIT + Depreciation – Taxes
Shark example:
OCF = 27,570 + 30,000 – 5,790 = 51,780
• Timeline of Cash Flows
Year OCF ΔNWC Capital Expenditure Net Cash Flow
0 — –20,000 –90,000 –110,000
1 51,780 — — 51,780
2 51,780 — — 51,780
3 51,780 +20,000 — 71,780
Recovery of $20,000 working capital happens at the end
Kristina El Haddad, Spring 25
• Calculating Cash Flows
Three Components of Project Cash Flow:
1. Operating Cash Flow (OCF) → cash generated during the project.
2. Change in Net Working Capital (NWC) → extra cash tied up in things like inventory.
3. Capital Spending → initial investment in assets (machines).
➔ Total Project Cash Flow = OCF – Change in NWC – Capital Spending
• Depreciation Methods
Straight-Line Depreciation:
Depreciation = (Initial Cost – Salvage Value) /Useful Life
MACRS Depreciation (Modified Accelerated Cost Recovery System):
Asset loses more value in early years
IRS provides tables with percentages per year.
Total percentages always = 100% (across asset life).
Example:
Year 1 = 20%, Year 2 = 32%, …
Bonus Depreciation:
We write off a big chunk of the asset immediately (for example, 100% in first year).
Kristina El Haddad, Spring 25
After bonus depreciation, the remaining is depreciated normally if anything remains.
If Book Value > Market value, then the accountant added depreciation
(BV – MV) * Tax Rate = The amount to be refunded
• Four ways to Calculate OCF
1. Bottom-Up Approach:
Start from Net Income:
OCF = Net Income + Depreciation
2. Top-Down Approach:
Start from Sales and Costs (ignore depreciation at first)
OCF = Sales – Costs – Taxes
3. Tax Shield Approach:
OCF = (Sales – Costs) × (1 – Tc) + Depreciation × Tc
4. Traditional Approach
OCF = EBIT + Depreciation – Taxes
All 4 methods give the same final OCF.
Remarks
Always recover Net Working Capital at the end
(whatever you invested at the start, you get it back at the end).
Depreciation lowers taxes even if it’s non-cash
(helps cash flow)
Kristina El Haddad, Spring 25
If Salvage Value ≠ Book Value:
Calculate tax gain or tax loss on the sale:
➔ Tax Refund = (Salvage – Book Value) × Tax Rate
Kristina El Haddad, Spring 25