Accounting profits are cash flows that include non-cash inflows/outflows such as depreciation.
Cash flows are a firm's actual cash inflows/outflows and are important in capital budgeting.
Example: Net Cash Flows
Assume Newco has $10,000 in annual depreciation and $20,000 in accounting net income. Because the $10,000 in annual depreciation is not an actual cash outflow, the $20,000 in accounting net income is not the true cash flow to the firm.
If, while all else is constant, annual depreciation were to decline by $5,000 to $5,000, accounting net income would increase to $25,000, but actual cash flow would remain unchanged. However, calculations of net cash flow exclude the effects of depreciation.
For purposes of capital budgeting,
Net Cash Flow = Net Income + Depreciation
Answer: Therefore, net cash flow would be equal to $30,000 ($20,000 net income +$10,000 depreciation) before the changes in depreciation and $30,000 ($25,000 net income + $5,000 depreciation) after the changes in depreciation.
Incremental Cash Flow and Capital Budgeting
Once a company makes a decision to accept a project, an incremental cash flow is then the cash flow that is added to the firm's existing cash flow as a result of accepting a new project.
However, in determining incremental cash flows from a new project, problems arise, such as:
1. Sunk Costs
These are the initial outlays required to analyze a project that cannot be recovered even if a project is accepted. As such, these costs will not affect the future cash flows of the project and should not be considered when making capital-budgeting decisions.
Suppose Newco is considering whether to make an addition to its current plant to increase production. To determine if the new addition is worthwhile, Newco hired a consulting firm for $50,000 to analyze the addition and the effect it will have on production. The $50,000 is considered a sunk cost. If the project is rejected, the $50,000 will still be paid, and if the project is accepted, the $50,000 will not affect the future cash flows of the addition.
This is the cost of not going forward with a project or the cash outflows that will not be earned as a result of utilizing an asset for another alternative. For example, the opportunity cost of Newco's new addition considered above is the cost of the land on which Newco is considering putting the new plant addition. As such, it should be included in the analysis of the project.
Additionally, in the consideration of incremental cash flows of a new project, there may be effects on the existing operations of the company to consider, known as "externalities". For example, the addition to Newco's plant is for the purpose of producing a new product. It must be considered if the new product may actually take away or add to sales of the existing product.
This is the type of externality where the new project takes sales away from the existing product.
Changes in Net Working Capital
A change in net working capital is essentially the changes in current assets minus changes in current liabilities. Within the capital-budgeting process, a project typically adds to current assets given additional inventories or potential increases in accounts receivables from new sales. The increases to current assets, however, are offset by current liabilities needed to finance the new project.
Overall, there may be change to net working capital from the new project.
- If the change in net working capital is positive, the change to current assets outweighs the change in the current liabilities.
- If, however, the change in net working capital is negative, the change to current liabilities outweighs the change in current assets.
Advantages and Disadvantages of the NPV and IRR Methods
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