CHAPTER SIX

LONG-TERM INVESTMENTS: FUNDAMENTAL ASPECTS

6.1. INTRODUCTION
Long-term investments are also called capital budgeting. The term capital according to Weston and
Brigham, 1985, refers to the fixed assets used in production, while a budget is a detailed plan of projected
cash flows during some future period. Thus, the capital budget of the firm outlines the planned expenditures
of the fixed assets, and capital budgeting is the whole process of analyzing projects whose returns are
expected to extend beyond the period of one year and deciding which project should be included in the
capital project. Capital budgeting expenditures include expenditures for land, building, equipment, and for
permanent additions to working capital associated with plant expansion, for advertising and promotion
campaigns, and for research and development programs.
The optimum capital budget is simultaneously determined by the interaction of supply and demand forces
under conditions of uncertainty. The forces of supply refer to the supply of capital to the firm, or its cost of
capital schedule. The forces of demand on the other hand, refer to the investment opportunities available for
the firm, as measured by the stream of revenues that will result from an investment decision. Uncertainty of
conditions enters the decisions because it is impossible to know exactly either the cost of capital or the
stream of revenues that will be derived from a project.
6.1.1. Importance of Capital Budgeting
The following are some of the importance of capital budgeting:
1. It has along-term effects. The result of capital budgeting decisions continues over an extended
period. This enables the firm to be competitive in the market by keeping its existing customers.
2. Effective capital budgeting will improve both the timing of assets acquisitions and the quality
of the acquired assets. Capital assets must be ready at the time they are needed. If the firm
forecasts its demand properly and plans its required capacity increases, it will be able to maintain
its market, (even to obtain a larger share of the market). A firm, which forecasts its capital assets
requirements in advance, will have the opportunity to purchase and install the asset before its sales
exceeds its capacity.
3. Capital budgeting enables the firm to raise funds early before the sales approach the
maximum capacity levels. Before the firm spends a large amount of money, it must take the
proper plans. Large amounts of funds are not available over night. A firm that contemplates a
major capital expenditure program may need to arrange its financing several years in advance to be
sure of having the funds required for the program.
6.1.2. Approaches to Capital Budgeting
A systematic approach to capital budgeting requires the following procedures to follow:
1. The formulation of long-term strategy and goals
2. The creative search and identification of new investment opportunities
3. The estimation and forecasting of current and future cash-flows
4. A set of decision rules that can differentiate acceptable from unacceptable alternatives.
5. The building of suitable administrative framework that is capable of transferring the required
information to the decision level.
6. The controlling of expenditures and the careful monitoring of project implementation.
If financial managers undertake all the 6-steps under the capital budgeting approach, they are able to make
effective capital budgeting decisions.
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 1. Formulation of Long-term Goals
Long-term goals serve as the guide for managerial decisions. A systematic approach to capital budgeting
decisions, thus, requires the formulation of a set of long-term goals. Management will be concerned with
both the expected returns and the risks assumed on its capital investment.
2. Generating Investment Proposals (Ideas)
A good investment proposal is not just born; some one has to suggest it. In addition, someone within the
firm must be willing to listen to such proposals. In the absence of creative search for new investment
opportunities, even the most sophisticated evaluation techniques may be worthless. In a firm with well
equipped research and development division, sophisticated new products, or processes are created by the
division. In a small firm, the search for investment possibilities may be less structured. It often takes the
form of employee suggestion box, or informal discussions during a coffee break.
The search for opportunities should include the acquisition of existing production and marketing facilities
by means of a merger with another company, as well as, the expansion of the company's own facilities or
the creation of an entirely new division. The long-term investment proposals may be classified as follows:
a) Replacement (Maintenance of Business): This refers to the expenditures necessary to replace worn
out or damaged fixed assets of the business firm.
b) Replacement (Cost Reduction): It refers to expenditures that are made to replace serviceable but
obsolete (outdated) equipments in order to lower the cost of labor, materials, or other items such as
electricity.
c) Expansion of Existing Products or Markets: These are expenditures necessary to produce new
product or to expand into a geographic area not currently being served.
d) Safety and/or Environmental Projects: These are expenditures necessary for complying with
government orders, labor agreements, and insurance policy terms. These expenditures are often
called mandatory investments, non-revenue producing investment.
In general, capital budgeting projects can be classified into three categories:
A. Cost Reduction Projects:
These projects are intended to reduce the firm's operating costs such as cost of labor, materials electricity
and so on. Cost reduction is achieved through the replacement of plants or fixed assets. The benefit from
cost reduction projects is cost savings.
B. Revenue Expansion Projects:
The main purpose of these projects is to increase the volume of sales (revenue) through the increased level
of output of the existing product, expanding product distribution outlets the markets current served,
introducing new products (product development, expanding (searching) the market into new geographical
areas (market development), and/or introducing new products for new markets (diversification). The
benefits are realized in the form of increased net cash inflows.
C. Non-Revenue Producing (Mandatory) Investments:
These projects are safety and/or environmental protection projects are safety and/or environmental
protection projects that are necessary for complying with government orders, labor agreements, or insurance
policy terms.
3. Forecasting Cash Flows
Once the investment proposals are identified, the next step is to forecast the cash flows (for revenue
expansion or cost saving projects). This is accomplished by determining expected revenues and costs for
each project. Even though the timing and size of future cash flows usually remain uncertain throughout the
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budgeting process, the proper estimation of the cash flows is vital. In the analysis of capital budgeting
decisions, annual cash flows are used instead of the accounting profits. Cash flows and accounting profits
can be very different because accounting profits include non-cash revenues and non-cash expenses.
In fact, accounting profits are important, but cash flows are often more important for the purpose of setting a
value of a firm. In the entire capital budgeting procedures, probably nothing is of greater importance than a
reliable estimate of the cost savings of revenue increase that will be achieved from the prospective outlays
of capital funds. All the subsequent analysis's we will discuss in this chapter are based on the cash flow
figures not the accounting profit figures. All the capital budgeting analyses are as successful as the data
input you are using. Capital budgeting procedures are performed by the group of experts such as engineers,
accountants, economists, cost analysts, and other qualified persons. The method of determining the cash
flows of the project will be discussed in this chapter later.
4. Ranking Investment Proposals
This activity involves the setting of decision rule(s) that help us to differentiate projects that are acceptable
and unacceptable. Then, we choose and/or make decision to accept the project alternative that is ranked
first as it will maximize the value of the firm. The main objective of the financial manager while
undertaking capital budgeting is to answer the following questions:
1. Which of the several mutually exclusive investment alternatives have to be chosen for
implementation? and
2. How many independent projects, i.e. projects that are not mutually exclusive, have to be
accepted?
Different techniques are used to rank and choose among many project alternatives. Some of these
techniques are the payback period, the accounting rate of return, the net present value method, the internal
rate of return, and the profitability index. Each one of these techniques will be discussed in detail in
Chapter 15 of this text book.
5. The Administrative Framework
Capital budgeting is a multi-dimensional activity that demands a high degree of cooperation among various
departments. The final approval of major capital expenditures, however, rests on the shoulders of the board
of directors of the company.
6. The Post-Completion Audit (Monitoring)
This step pertains to implemented project alternative(s). The post-completion audit involves careful
monitoring of project implementation and is a necessary managerial tool. A careful analysis of deviations
of actual performance from planned levels enables to take feedback and may prevent poor performance
history from repeating itself in future projects. The post-completion audit can be a better and rewarding
experience for decision makers. The post-completion audit has two principal objectives. These are to
improve the accuracy of forecasts and to improve the firm’s operations.
6.1.3. Assumptions that underlie Capital Budgeting
A number of assumptions must be introduced in order to concentrate on the managerial aspect of capital
budgeting. The effect of these assumptions is to exclude non-financial considerations and to remove some
complications that obscure the major points under capital budgeting. These assumptions constitute a
general set of conditions within which the financial aspects of long-term alternatives can be evaluated. You
can use any one of the capital budgeting/cash flow evaluation/ criteria and techniques presented in the next
chapter only when the following assumptions are fulfilled:
 Shareholders' Wealth Maximization is the Basic Motive of Capital Budgeting Decision. All
capital budgeting alternatives considered here are accepted or rejected on the basis of their effect on
shareholders' wealth. No other company's goals influence the investment selection decisions.
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  Costs and Revenues are known With Certainty. The costs and revenues associated with each
investment alternative are known with certainty, or there exists a forecasting technique that can
generate the values with a very small error. It may be very difficult to estimate revenues and costs
more than two or three years into the future. However, if a proposed investment has a ten year
economic life, accurate forecasts must be available for all ten years.
 Inflows and Outflows of Cash Occur once a Year. This assumption is important in order to
compute the present and future values of cash flows, because capital budgeting criteria use
discounting techniques. Cash inflows or outflows are assumed to occur only once a year (i.e. either
at the end of a given year or at discrete yearly intervals. Hence, compounding and/or discounting
occur only once a year.
 Inflows and Outflows are based on Cash. The data required for evaluating investment proposals
must be stated in cash as opposed to the accounting income. This is because of the fact that the
company uses cash to pay its bills and to pay cash dividends on common and preferred stock. If the
business firm does not generate cash returns from its investments, it will sooner or later become
insolvent.
 Cash Flows Exhibit a Conventional Pattern. The fund that is required to undertake an investment
represents inflows to the company, and the returns from the investment represents outflows from the
company. If we represent the cash outflows with the minus "-" sign and the cash inflows with the
plus "+" sign, then the conventional cash flows under capital budgeting is defined as the time series
of cash flows that contains only one change in sign. For example, if an investment alternative has
one cash outflow followed by three cash inflows can be represented as: -, +, +, +. This is
considered to have a conventional cash flow pattern. Investment alternatives are assumed to
exhibit conventional cash flows. Evaluating an investment alternative that violates this assumption
can become very difficult.
 The Required Rate of Return is known and constant. The required rate of return is generally
looked at as the minimum rate of return that the company must earn if shareholders' wealth is not to
decrease. Here, the minimum required rate of return on investment alternatives is assumed to be
known and constant over the life of the proposed investment. Arriving at the required rate of return
is important for two reasons:
1. If the rate is too high, the company will end up in rejecting quite profitable projects,
and
2. If the rate is too small or low, the company will end up in accepting projects that are not
profitable and decrease shareholders wealth.
 Capital Rationing doesn't exist. Whenever a company is not able to finance its entire capital
budgeting (investment), capital rationing is said to exist. In such a situation, some investments will
have to given up. The cash flow evaluation and accept/reject decisions to be made in the next chapter
considers that there is no any capital problem or limitation. However, capital rationing or capital
shortage does contain important implications for financial managers. Chapter 15 also discusses capital
budgeting decisions when rationing exists.
6.2. Parts of Investment and Cash Flow Concept
Investment has been defined as a long-term commitment of economic resources made with the objective of
producing and obtaining net gains in the future. The conventional methods of investment appraisal
basically evaluate the expected net profit (sales income less costs and incomes taxes) against the capital
invested. For the purpose of investment appraisal, it is necessary to assess and evaluate over a certain
period, all inputs required and all outputs produced by the project. That is why the concept of cash flows is
developed.

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In this regard, the cash-flow concept is needed for planning of the flow of financial means, in other words,
the sources and application of funds. The appraisal of long term investments is made in terms of cash flows
that occur at different stages in the capital budgeting process. Literally, there are three parts of cash flows in
long-term investments. These are:
1. The initial investment. The initial investment is an outlay of cash that takes place at the
beginning of the life of the project.
2. The operating cash flows. The operating cash inflows from revenue sources and the cash
outflows for different expenditures.
3. The terminal cash flows. These are the cash inflows and outflows that take place at the end of
the project life.
In addition, the discounted cash-flow concept has become the generally accepted method for investment
appraisal. The basic assumption underlying the discounted cash-flow concept is that money has a time
value, in so far as a given sum of money available now is worth more than an equal sum available in the
future. One Birr today is more valuable than one Birr a year hence. This is because:
 Individuals, in general, prefer current consumption to future consumption.
 Capital can be employed productively to generate positive returns. An investment of one Birr
today would grow to (1 + r) a year; where (r is the rate of return earned on the investment).
 In an inflationary period, one Birr today represents a greater real purchasing power than one Birr
a year after.
Many financial problems involve cash flows occurring at different points of time. For evaluating such cash
flows an explicit consideration of time value of money is required. This difference can be expressed as a
percentage rate indicating the relative charge for a given period, which is usually a year. Considering a
project may obtain a certain amount of funds “F”, if this sum is repaid after one year including an agreed
interest “I”, the total sum to be paid after one year would be (F + I), where:
F + I = F (1 + r)
And r is defined as the interest rate (in % per year) divided by 100. If the interest rate is, for example, 12%,
then r equals 0.12.
Suppose that “CFn” is the nominal value of a future cash flow in the year “n”, and “CFpv” is the value at
the present time (present value) of this expected inflow or outflow, then (assuming r is constant):
n
CFpv = CFn/ (1 + r) or
CFpv = CFn (1 + r) –n
The general formula for the future value of a single amount is:
FV = PV (1+k) n
Where: FV = Future value after “n” years
PV = Amount today (present value)
K = Interest rate per year
n = Number of years for which compounding is done.
6.3. Fundamentals of Cash Flow Projection
6.3.1. General

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  Estimating cash flows: Estimating project cash flows, i.e. investment outlays and subsequent cash
inflows after the project is commissioned, is the most important but also the most difficult step in
capital budgeting.
 Forecasting project cash flows involves numerous variables and different professionals may
participate in this exercise.
 Capital outlays are estimated by engineering and product development departments.
 Revenue projections are provided by the marketing group.
 Operating costs are estimated by production people, cost accountants, purchase managers,
personnel executives, tax experts, and others.
 The role of the finance manager is to:
 Coordinate the efforts of various departments and obtain information from them,
 Ensure that the forecasts are based on a great deal of consistent economic assumptions,
 Keep the exercise focused on relevant variables, and
 Minimize the biases inherent in cash flow forecasting.
6.3.2. Elements of the Cash Flow Stream
To evaluate a project, you must determine the relevant cash flows, which are the incremental after tax cash
flows associated with the project.
A. Cash Flow Stream
i. Initial investment cash flows:
Includes the after tax cash outlays on capital expenditures and net working capital when the project is set up.
 Leasing of land
 Machinery, equipment, tools, etc
 Installation, testing, and start-up costs
 Additional investment in NWC.
[NB. Often government units encourage investors by providing various investment incentives. One of these
incentives is the investment tax credit that is netted against the initial investment outlay, since it is an
inflow to the firm.]
ii. Operating Cash Flows:
 The after tax cash inflows resulting from the operations of the project during its economic life are called
operating Cash Flows. The net operating cash flows could be positive or negative. If we assume
conventional cash flow pattern, the net operating cash flow will be positive.
iii. Terminal Cash Flows:
The after tax cash flows resulting from the termination of the project and the disposal of its assets at the end
of its economic life.
 Salvage proceeds from disposal of assets net of tax (inflow)
 Recovery of net working capital (inflow)
 Liquidation and disposal costs (outflow)
 Tax paid on gain on disposal of old assets (outflow)

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  Tax saving/tax shield due to loss on disposal of old assets ( benefit/treated as an inflow)
B. Time Horizon for Analysis
The time horizon for cash flow analysis is generally the minimum of the following:
i. Physical life of the machineries and equipments/Technical life of plant Asset
 Period during which the plant remains in a physically usable condition
 The number of years the machineries & equipments in the plant would perform the functions for
which they had been acquired
 It depends on the wear and tear which the plant is subject to
 Suppliers of the plant’s machineries and equipments may provide information on the physical
life under normal operating conditions
 While the concept of physical life may be useful for determining the depreciation charge, it is
not very useful for investment decision making purposes
ii. Technological life of the machineries and equipments in the plant
 New technological developments tend to render existing machineries and equipments in the
plant obsolete.
 The technological life of a plant refers to the period of time over which the present plant
would not be rendered obsolete by a new plant.
 It is very difficult to estimate because the pace of new developments is not governed by any
law. Yet, an estimate of the technological life has to be made.
iii. Product Market life of the plant (Product Life Cycle):
 A plant may be physically usable, its technology may not be obsolete, but the market for its products
may disappear or shrink and hence, its continuance may not be justified.
 The product market life of a plant refers to the period over which the product of the plant enjoys
reasonably satisfactory market
iv. Investment Planning Horizon of the firm:
It refers to the time period for which a firm wishes to look ahead for purpose of investment analysis. It
naturally tends to vary with the complexity and size of the investment. For Example, the following rough
estimate can be used:
 Small investment, (Replacement decisions), may be 5 years
 Medium size investments, (Expansion of plant capacity), may be 10 years
 Large size investment, (Setting up a new division), may be 15 years
6.3.3. Basic Principles of Cash Flow Estimation
1. Principle of Cash Flow
Project evaluation should be based on its cash flows instead of accrual income measurement concept.
Rationale:
 It is cash that can be reinvested in other projects.
 The accounting data (i.e. income) is difficult to understand because it is full of technical jargons.
 Different accounting approaches & treatments would result in different net income figures even in the
absence of differences in operations.
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 2. Financial Cost Exclusion principle
There are two sides of a project: the investment (or asset) side and the financing side. The cash flows
associated with these sides should be separated.
Projects

Investment side Financing Side

side outflows
Investment Financing inflows (Funds)
Return on investment Financing costs & expenses (outflows)
[It is an inflow] [Included in the cost of capital]
Note that the cash flows on the investment side of the project should exclude financing costs and expenses
(i.e. interests & dividends).The financing costs are included in the cash flows on the financing side and
reflected in the cost of capital. In this regard, the cost of capital is the hurdle rate with which the rate of
return on the investment side will be judged or evaluated. Since the financing costs are included in the cost
of capital, any inclusion of these costs in the investment cash flows will result in double counting of costs.
Therefore, while defining the cash flows on the investment side, financing costs should not be considered
because they are already reflected in the cost of capital figure against which the rate of return figure will be
evaluated. If interest is deducted in the process of arriving at profit after tax, an amount equal to “Interest X
(1-Tax rate)” should be added to the “profit after tax”. Below is the adjustment to be made on the after tax
operating profit:
EBIT (1 – T) = Operating Profit After Tax (OPAT)
(EBT + Interest) x (1 – T) = Adjusted Operating Profit After Tax /PAT
(EBT)(1-T) + Interest (1-T) = PAT ; [Note that EBT x (1-T) = EAT]
EAT + Interest (1-T) = Adjusted Operating Profit After Tax (or Operating Earning After Tax)
[Note that the after tax balance of interest is added back as per the adjustment because the tax advantage
from paying interest, i.e. the tax shield, is already considered in the computation of the net cost of debt
capital.]
3. Incremental principle
The cash flow of a project must be measured in incremental terms. Look at what happens to the cash flows
of the firm with and with out the project:
Project cash Flows = Cash Flows for the firm – Cash Flows for the
for year (t) with the project for firm without the
[Incremental cash flows] Year (t) project for year (t)
Guidelines:
A. Consider all Incidental effects
In addition to the direct cash flows of the project, all its incidental effects on the rest of the firm must be
considered. The project may enhance the profitability of some of the existing activities of the firm because it
has a complementary relationship with them or it may detract from the profitability of some of the existing
activities of the firm because it has a competitive relationship with them. Such incidental effects should be
taken in to account.

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 B. Ignore sunk costs
A sunk cost is an outlay already incurred in the past or already committed irrevocably. Sunk costs cannot be
recovered and hence, are not relevant. So, it is not affected by the acceptance or rejection of the project or
do not influence the project related decisions. Sunk costs are not differential, i.e. they do not vary among
alternatives.
C. Include Opportunity costs
If a project uses resources already available with the firm, there is a potential for an opportunity cost. It is a
cost created for the rest of the firm as a consequence of undertaking the project. The opportunity cost of a
resource is the benefit forgone that would have been derived from it by putting it to its best alternative use.
That is, the resource might have been rented out, sold, or required else where in the firm
D. Estimate working capital properly
Apart from fixed costs, a project requires working capital investment. Outlays on working capital have to be
properly considered while forecasting the project cash flows. Working capital (or more precisely, net
working capital) is defined as:
[Current assets] - [Current liabilities]
The requirement of working capital is likely to change over time.
 While fixed asset investments are made during the early years of the project and depreciate overtime,
working capital is renewed periodically and hence, is not subject to depreciation
 Thus, the working capital at the end of the project life is assumed to have a salvage (or recovery)
value equal to its book value. Sometimes, the net working capital may not be fully recovered due to
uncollectible balances.
E. Post – Tax Principle
Cash flows should be measured on an after-tax basis. Some firms may ignore tax payments and try to
compensate this mistake by discounting the pre-tax cash flows at a rate higher than the cost of capital of the
firm. Since there is no reliable way of adjusting the discount rate, you should always use after – tax cash
flows along with after tax discount rate.
F. Treatment of losses
Because the firm as well as the project can incur losses, let us look at various possible combinations and the
ways to deal with them:
Scenario Project Firm Action
1 Losses Losses Defer tax savings
2 Losses Profit Take tax savings in the year of loss
3 Profits Losses Defer taxes until the firm makes profit
4 Profits Profit Consider taxes in the year of profit
Stand Alone Losses _ Defer taxes savings until the project makes profits
G. Effect of Non-Cash Charges
Non cash charges can have impacts on cash flows if they affect tax liability, for example, depreciations.
Tax benefit of depreciation is computed as: [Amount of Depreciation x Tax rate]
H. Consistency Principle

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Cash flows and the discount rates applied to these cash flows must be consistent with respect to the investor
group & choices for valuation.
i) Investor group:
Case 1: The cash flow available to all investors after paying taxes and meeting investment needs of the
project. Cash flow to all investors is computed as:

= EBIT (1 – T)
+ Depreciation/other non-cash charges
Case 2: The - Capital expenditures cash flow of a project from the point
of view equity share holders is the cash flow
available to - Changes in net working capital equity share holders after paying
taxes, meeting investment needs, and fulfilling debt related commitments.
Cash flow to equity shareholders = Profit After Tax (PAT)
+ Depreciation & other non cash charges
- Preference dividend
- Capital expenditures
- Changes in net working capital
- Repayment of debts
+ Proceeds from debt issues
- Redemption of preference capital/stocks
+ Proceeds from new preference issues

The discount rate must be consistent with the definition of the cash flow.
Cash Flow Discount Rate
Cash flow to all investors Weighted average cost of capital (WACC)
Cash flow to equity holders Cost of equity capital
ii. Choices:
Incorporate expected inflation in the estimates of future cash flows and apply a nominal discount rate to the
same .Or else, estimate the future cash flows in real terms and apply a real discount rate to the same.
Relationship between nominal and real values:
Nominal Cash Flow (t) = Real cash flow (t) x (1 + Expected inflation rate) t
Nominal discount rate = (1 + Real discount rate) x (1 + Expected Inflation rate) – 1
Therefore, a match should also exist between the type of the cash flow and the discount rate used.

Cash Flow Discount Rate

Nominal cash flow Nominal discount rate
Real cash flow Real discount rate
Generally, in capital budgeting analysis, nominal cash flows are estimated and nominal discount rates are
used.
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 6.4. Determining Project Cash Flows
6.4.1. Component Cash Flow Determination
1. Net Initial Investment (NINV):
The net initial investment, (NINV,) in a project is defines as the project’s initial net cash outlays, that is, the
outlays at time period zero/now. It is calculated using the following steps:
Step 1: The new project cost plus any installation and shipping costs, import tariffs, and other
costs associated with acquiring the asset and putting it in to service,
[The asset cost plus installation and shipping costs from the basis up on which depreciation is
computed]
Plus
Step 2: Any increase in Net working capital initially required as a result of the new investment,
Minus
Step 3: Gross proceeds from the sale of existing assets, i.e. selling price of old assets, when the
investment is a replacement decision,
[This normally is computed as the actual salvage value of the asset being replaced less any costs
associated with physically removing or selling it].
Plus or minus
Step 4: Taxes associated with the sale of the existing assets,
[Taxes associated with gain on disposal of the old asset or tax savings due to loss on disposal.
The total tax effect may be either positive or negative, that is why it is either added to or
subtracted from the new project cost].
2. Net (Operating) Cash Flows (NOCFs)
The process of estimating incremental cash flows associated with a specific project is an important part of
the capital budgeting process. Capital budgeting is concerned primarily with the after tax (net) operating
cash flows, (NOCFs), of a particular project, or change in cash inflows minus change in cash outflows.
For any year during the life of a project, the NOCF may be defined as the change in operating earnings after
taxes, (∆OEAT), plus the change in depreciation, (∆ Depreciation), minus the change in the net working
capital investment required by the firm to support the project, (∆ NWC).
NOCF= ∆OEAT +∆ Depreciation - ∆ NWC
Operating earnings after tax, (OEAT), differ from earnings after tax, (EAT), because OEAT does not
consider interest expenses in its calculations. Net Operating Cash Flows, NOCFs, as used for capital
budgeting purposes, normally do not consider financing charges, such as interest, because these financing
charges will be reflected in the cost of capital that is used to discount project cash flows.
In years when a firm must increase its investment in net working capital (NWC) associated with a particular
project, this increased investment in NWC reduces NOCF. Normally, however, at the end of the life of the
project, the NWC investment accumulated over the life of the project is recovered (for example, as
inventories are sold and accounts receivable are collected). Thus, ∆ NWC is negative (a reduction) at the
operating stage. If a decline in the net working capital is expected over the life of the project, the effect
would be to increase the NOCF of the project, however.
Thus, the NOCF of a project is computed as follows:
Change in Revenue -------------------------------------------------------- ∆R
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 Less: Change in operating costs---------------------------------------- – ∆OC
Change in depreciation---------------------------------------- – ∆ Depreciation
Equals: Change in Operating earnings before tax ------------------- ∆ OEBT
Less: Taxes---------------------------------------------------------------- – T (∆OEBT)
Equals: Change in operating earnings after tax -------------------- ∆OEAT
Plus: change in depreciation----------------------------------------------- +∆Depreciation
Less: Change in Net working capital (Increase) ------------------------ – ∆NWC
Equals: Net operating cash flow (Annual)------------------------------- NOCF
[NB. ∆ NWC can occur as part of the net investment at time zero (0) or at any time during the life of the
project. Furthermore, the NOCF of the final year of the project is characterized by cash flows associated
with disposal of old assets of the project and recovery of the cumulative NWC].
In this regard, the disposal price of the old assets and the associated gain or loss would affect the amount of
the after tax cash proceeds obtained.
Cases
 Old assets are sold for more than their original cost. The amount in excess of the original cost is
treated as capital gain and hence, taxed at capital gain tax rate. The amount in between original
cost and book value is taxed at ordinary tax rate.
 Salvage proceeds (selling price) of the old assets is less than the current book value. The loss
incurred would reduce the taxable income and brings a tax saving, which is an implicit cash
inflow to be recognized. The NOCF should include the salvage proceeds plus the tax saving
arise.
 Salvage proceeds (selling price) of the old assets is equal to the current book value. There will be
no gain or no loss and hence, only the salvage proceeds will be included as an inflow of cash.
6.4.2. Summary of Project Cash Flow Determination
1. Investment Phase: Determination of net initial investment (NINV):
A. New project case:
NINV= Cost of project + Investment in NWC
- Investment tax credit
B. Replacement (Cost Reduction) projects:
NINV = Cost of replacement assets - Net disposal proceeds of old assets
Where: Net disposal proceeds = Selling price of OA – Taxes on gain on disposal
Or Selling price of OA + Tax savings (shield) on loss on disposal
[In general, replacement projects do not require additional investment in net working capital].
C. Expansion projects:
NINV= Cost of New Assets + Increase in NWC
- Net disposal proceeds on OA
2. Operating Phase: Determination of net operating cash flows (NOCFs):

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 New project Replacement or Expansion
Case 1 Case 2 Case 1 Case 2
Revenue Revenue ∆ Revenue ∆ Revenue
- Operating costs - Operating costs - ∆Operating costs - ∆Operating costs
- Depreciation - Depreciation - ∆Depreciation - ∆Depreciation
EBIT EBIT ∆EBIT ∆EBIT
- Interest - - Interest -
EBT OEBT ∆ EBT ∆ OEBT
- Tax - Tax - ∆Tax - ∆Tax
= EAT = OEAT = ∆EAT = ∆OEAT
Adjustments: Adjustments: Adjustments: Adjustments:
+ Depreciation + Depreciation + ∆Depreciation + ∆Depreciation
+ Interest (1-T) __ + Interest (1-T) -
- ∆NWC - ∆NWC (Expansion) - ∆NWC - ∆NWC(Expansion)
∆NOCF ∆NOCF ∆NOCF ∆NOCF

[Note: Case 1 here shows the process of adjustment needed in the determination of project cash flows
if interest is initially deducted as an expense; and Case 2 shows the adjustment if interest charges
were not deducted. T is the tax rate and the after tax balance of interest is obtained by multiplying it
by (1 – T)].
3. Termination Stage:
Terminal Cash Flows = NOCF of the final year
Add: + Recovery of NWC
Net disposal + Selling price of old assets
proceeds from old
+ Tax savings on loss on disposal, or
assets
- Additional taxes on gain on disposal
+ Tax savings on bad debt losses/uncollectible accounts/, if any

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