How should the cash flows properly attributable to aproposed new project be calculated?Here is a checklist to bear in mind when forecasting aproject’s cash flows:• Discount cash flows, not profits.• Estimate the project’s incremental cash flows—that is,the difference between the cash flows with the projectand those without the project.• Include all indirect effects of the project, such as itsimpact on the sales of the firm’s other products.• Forget sunk costs.• Include opportunity costs, such as the value of landthat you could otherwise sell.• Beware of allocated overhead charges for heat, light,and so on. These may not reflect the incremental effectsof the project on these costs.• Remember the investment in working capital. As salesincrease, the firm may need to make additional investmentsin working capital and, as the project finallycomes to an end, it will recover these investments.• Do not include debt interest or the cost of repaying aloan. When calculating NPV, assume that the project isfinanced entirely by the shareholders and that theyreceive all the cash flows. This isolates the investmentdecision from the financing decision.
How can the cash flows of a project be computed fromstandard financial statements?Project cash flow does not equal profit. You must allowfor changes in working capital as well as non-cashexpenses such as depreciation. Also, if you use a nominalcost of capital, consistency requires that you forecastnominal cash flows—that is, cash flows that recognize theeffect of inflation.
How is the company’s tax bill affected by capital costallowance (CCA) and how does this affect projectvalue?CCA is not a cash flow. However, because CCA reducestaxable income, it reduces taxes. This tax reduction iscalled the CCA tax shield. For computing tax depreciationin Canada, assets are assigned into different assetclasses, which have specified CCA rates. Most assetclasses follow a declining balance system for computingCCA, and, therefore, most assets continue to generateCCA tax shields over an infinite time frame. Because ofthis, we find the present value of operating cash flowsseparately from the present value of the CCA tax shieldsto determine the net present value of a project.
How do changes in working capital affect project cashflows?Increases in net working capital, such as accountsreceivable or inventory, are investments and, therefore,use cash. That is, they reduce the net cash flow providedby the project in that period. When working capital is rundown, cash is freed up, so cash flow increases.
