Lesson 2B:

Project Cash Flows

“Cash is king!”
- origin unknown
 Roadmap for Lesson 2B
• Calculations for Key Cash Flow
Components
– Operating Cash Flow
– Changes in NWC
– Net Capex
• Putting it Together: Project FCF
 Calculations for Key
Cash Flow Components
Incremental Earnings & Operating CF
Unlevered Net Income = EBIT(1-tax rate)

Operating Cash Flow (OCF) = Unlevered NI + Depr

OCF = EBIT(1-t) + Depr
OCF = (Rev – Costs – Depr)(1- t) + Depr
OCF = (Rev – Costs) (1- t) + t× Depr
1) ‘Rev’ is incremental project revenue
2) ‘Costs’ include both incremental fixed and variable cash operating costs
3) ‘Depr’ is the incremental depreciation for the project
4) Taxes computed in this way do NOT account for deductions for interest
expense, so do not reflect interest tax shields.
 Example #1 (Expansion OCF)

• Your firm is considering a new three-year

expansion project that requires an initial fixed
asset investment of $2.7 million. The capex
will be depreciated straight-line to zero over its
three-year tax life. The project is expected to
generate $2,080,000 in annual sales, with
annual operating costs of $775,000. If the
tax rate is 35 percent, what is the annual
operating cash flow (OCF) for this project?
 Example #2 (Replacement OCF)
• Your firm has a marginal tax rate of 20
percent. You are considering replacing a piece
of machinery that has a remaining useful life
of 10 years and is being depreciated at
$140,000 per year. The replacement machine
also has a life of 10 years and it would be
depreciated at $160,000 per year. The higher
efficiency of the new machine would reduce
operating costs by $1,000 per year. What is
the operating cash flow (OCF) for this project?
 Net Working Capital
NWC = Operating Current Assets – Non-Interest
Bearing Current Liabilities
= Operating Cash + Inventory + Receivables
- Payables

∆NWC = Ending NWC – Beginning NWC

NWC investment is ALWAYS
recovered at the end of the
project’s (finite) life.
 Simple Net Working Capital Models

• Given NWC investments at the beginning of a

project, we can create simpler models of future
NWC in one of three ways:

1. NWC will not grow; no additional investment after time 0.

2. NWC will grow at a rate of X percent per period.

3. NWC will equal Y percent of sales (revenues) each period.

 Example #3
• Consider a $5,000 initial investment in net working
capital and a year one sales forecast of $65,000
with sales expected to grow at 6 percent per year
over the 4-year life of the project. Calculate
changes in NWC based on the assumption that
NWC will remain constant over the project life:
Year 0 1 2 3 4
NWC 5,000
ΔNWC
 Example #4
• Consider a $5,000 initial investment in net working
capital and a year one sales forecast of $65,000
with sales expected to grow at 6 percent per year
over the 4-year life of the project. Calculate changes
in NWC based on the assumption that NWC will be
10% of sales:
Year 0 1 2 3 4
Sales 65,000 68,900 73,034 77,416
NWC 5,000
ΔNWC
 Capital Expenditures
• Net Capital Expenditure (Net Capex) = cash spent to
purchase new fixed assets net of any cash received
from the sale of existing fixed assets.

• Fixed Assets are depreciated over time on the firm’s

balance sheet.
– Depreciation is a non-cash expense so it is only relevant
because it affects taxes.
– The depreciation schedule used for capital budgeting
purposes should be what the IRS requires for tax
purposes.
 Computing Depreciation
• Straight-line depreciation
– A fixed percentage of the asset basis is depreciated
each period (not generally used for tax purposes).
• MACRS
– Need to know which asset class is appropriate (see Table
8A.1 of Berk & DeMarzo text)
– Multiply percentage given in table by the initial cost
Note: With either method, we ignore any
expected future salvage value of the asset in
our depreciation calculations (i.e., we ALWAYS
fully depreciate the asset to a zero value).
 Asset Sales
Net Capex = Purchases of Fixed Assets – Net Proceeds from
Sales of Fixed Assets

Net Proceeds (NP) from an Asset Sale depends on:

1) The selling price (SP), or salvage value, of the asset.
2) Book value (BV) of the asset at the time of the planned sale.
3) The firm’s tax rate (t).

Basis = Cost + Delivery/Modification Charges

BV = Basis – Accumulated Depreciation
Net Proceeds: NP = SP – t (SP – BV)
 Example #5
• Consider a project that requires a fixed asset
investment of $50,000. The asset is classified as a
5-year asset under MACRS even though the
economic life of the project is only 3 years, and the
asset is expected to have a salvage value of $15,000
at the end of three years. The firm’s tax rate is 21%.
Complete the table on the next slide to estimate
depreciation expense and the ending book value of
this asset for each year of the project, as well as the
net capital expenditures for the project.
 Example #5
Year 0 1 2 3
Asset Purchase $50,000 0 0 0
MACRS % 20.00 32.00 19.20 11.52
Depreciation
Book Value
Asset Sale
Net Capital
Expenditure
 2017 Tax Cuts & Jobs Act (TCJA)
• Lowers corporate federal tax rate from 35% to 21% and
expands the definition of property that can be expensed
rather than depreciated.
• Eligible property gets “bonus depreciation” the year the
property is put in service
– Effectively a version of MACRS with 100% depreciation rate in year
0. Note “year 0” in the MACRS schedule can be thought of as
“year 1” in our usual straight-line calculations.
• Only applies to new property, not existing assets.
• Temporary provision; does not apply to property placed in
service after Jan. 1, 2023.
See Depreciation “Cascade” Excel
 Operating Cash Flow
Cash Flow
OCF = EBIT(1-t) + Depr
Component
OCF = (Rev – Costs – Depr)(1- t) + Depr
Formulas OCF = (Rev – Costs) (1- t) + t× Depr

Net Working Capital

Capital Expenditures
NWC = Cash + Inventory
+ Receivables – Payables Net Capex = Purchases of Fixed Assets
– Net Proceeds from Sale of Fixed Assets
∆NWC = Ending NWC Basis = Cost + Delivery/Modification Charges
– Beginning NWC Book Value: BV = Basis – Accumulated Depreciation
Net Proceeds on Sale: NP = SP – t (SP – BV)
Project Free Cash Flows
 Putting it Together: Project Cash Flow

Project Cash Flow* = Operating Cash Flow

– Changes in Net Working Capital
– Net Capital Expenditures

a.k.a. “Free Cash Flow”

 Project Cash Flow Structure

Year 0 1 to (N-1) N
Operating Cash Flow Usually zero OCFt OCFN
∆NWC Initial investment Changes (or zero) Recapture
Net Capex Initial investment Often zero Salvage
FCF = OCF - ∆NWC - Net Capex
 Project Cash Flow Structure

Year 0 1 to (N-1) N
Operating Cash Flow Usually zero OCFt OCFN
∆NWC Initial investment Changes (or zero) Recapture
Net Capex Initial investment Often zero Salvage
FCF = OCF - ∆NWC - Net Capex

For an infinite-lived project, these two items are replaced by a

“continuation” or “terminal” value (i.e., an estimate in time N
dollars of the value of the perpetuity of CFs from N+1 onward).
 Project Evaluation

Once you have calculated free cash flow for each year
of the project’s life (including time zero), apply any
of the project evaluation techniques we learned in
the our Fundamentals course (e.g., NPV or IRR).
 Example #6
• Your firm is considering a new processing system
with an installed cost of $480,000. This asset will
be depreciated straight-line to zero over the 5-year
project life, but is estimated to have a market
value of $70,000 at the end of year 5. The system
will save the firm $160,000 per year in pretax
operating costs, but it will require an initial
investment of $29,000 in net working capital. If
the firm’s tax rate is 21% and the project cost of
capital is 10%, what is the NPV of this project?
Replacement Problem

What if we have
an old asset to
replace with a
new asset?
In this case, incremental
cash flows are the changes
in the firm’s cash flows with
the new asset versus what
the cash flows would be if
the firm kept the old asset.
 Example #7
• Your firm is replacing a computer. The new
system costs $10,500 plus $1,000 shipping
(for a total tax basis of $11,500). The old
computer has a book value of $3,000 and can
be sold today for $2,500. The new system
requires a $4,000 increase in net working
capital. The tax rate is 35%. What is the
initial outlay (i.e., cash flow at time zero) for
this project?
Think about annual OCF and Net Capex at the end of the project.