Making Capital Investment Decisions | Corporate Finance | CMA Exam | CPA Exam BEC

These lectures cover stand-alone principle., incremental cash flow, Pro forma financial statements, noncash deduction, net working capital and discounted cash flow.

Project Analysis Cash Flow

Pro Forma Financial Statements and Project Cash Flows |Corporate Finance

Net Working Capital | Corporate Finance

Depreciation on Cash Flow Effect | Corporate Finance

Alternative Definitions of Operating Cash Flows | Corporate Finance

Cost Cutting Proposal Using Discounted Cash Flows | Corporate Finance

Setting Bid Price Using Discounted Cash Flow | Corporate Finance

A relevant cash flow for a project is a change in the firm’s overall future cash flow that comes about as a direct consequence of the decision to take that project. Because the relevant cash flows are defined in terms of changes in, or increments to, the firm’s existing cash flow, they are called the incremental cash flows associated with the project.
The concept of incremental cash flow is central to our analysis, so we will state a general definition and refer back to it as needed:
The incremental cash flows for project evaluation consist of any and all changes in the firm’s future cash flows that are a direct consequence of taking the project.
THE STAND-ALONE PRINCIPLE
In practice, it would be cumbersome to actually calculate the future total cash flows to the firm with and without a project, especially for a large firm. Fortunately, it is not really necessary to do so. Once we identify the effect of undertaking the proposed project on the firm’s cash flows, we need focus only on the project’s resulting incremental cash flows. This is called the stand-alone principle.

What the stand-alone principle says is that once we have determined the incremental cash flows from undertaking a project, we can view that project as a kind of “minifirm” with its own future revenues and costs, its own assets, and, of course, its own cash flows. We will then be primarily interested in comparing the cash flows from this minifirm to the cost of acquiring it. An important consequence of this approach is that we will be evaluating the proposed project purely on its own merits, in isolation from any other activities or projects.

 

Pro forma financial statements are a convenient and easily understood means of summarizing much of the relevant information for a project. To prepare these statements, we will need estimates of quantities such as unit sales, the selling price per unit, the variable cost per unit, and total fixed costs. We will also need to know the total investment required, including any investment in net working capital.
PROJECT CASH FLOWS
To develop the cash flows from a project, we need to recall that cash flow from assets has three components: operating cash flow, capital spending, and changes in net working capital.

Net working capital is a financial measure that determines if a business has enough liquid assets to pay its bills that are due in one year or less.
A business can determine its ability to pay its liabilities as they become due by calculating net working capital.

Accounting depreciation is a noncash deduction. As a result, depreciation has cash flow consequences only because it influences the tax bill. The way that depreciation is computed for tax purposes is thus the relevant method for capital investment decisions.