When determining the cash flows associated with a capital investment decision, only incremental cash flows should be counted, accounting profits are necessary only to determine taxes, an increase in working capital is effectively the same as an outlay of cash, capital investments must be depreciated and the faster the better, tax losses generate credits that are typically assumed to reduce tax payments elsewhere in the firm and thereby increase cash flow, and the sale of an investment can result in taxes if the selling price differs from the book value.
New investments must create value on their own. They cannot be credited with value created by existing projects. Hence, we consider only incremental cash flows, i.e., those that arise strictly as a result of the new project.
The net income created by a new project is virtually meaningless. Net income is important only in that it is derived taxable income, which is necessary to determine the taxes. Taxes are a definite cash flow. Net income is not cash flow.
Because accounting figures such as sales, cost of goods sold, and other expenses are not actual cash flows, adjustments must be made. Sales that are made but not collected will result in an increase in receivables but not cash. Inventory purchases and other expenses not paid in cash are counted as expenses but increase payables. To convert accounting figures into cash flow, increases in net working capital must be accounted for as though they were cash outlays. That is, deducting increases in working capital convert accounting figures to cash figures.
Unlike short-term expenses, capital investment expenditures cannot be deducted from pre-tax income. They must be depreciated. It is to the companyís advantage to write off its expenses as fast as possible. Accelerated depreciation is better than straight-line depreciation, because the cost of the investment is written off earlier, which reduces the present value of taxes.
If taxable income turns out to be a loss, we still multiply it by the tax rate. The resulting figure is a negative tax and can be viewed as a tax credit. This means that the application of this loss to the firmís other income reduces the overall taxes by the amount of the tax credit.
If an asset is sold at a value different from its book value (cost minus accumulated depreciation), there is a taxable gain or loss. We must compute the tax and subtract it if a taxable gain or add it if a taxable loss to the sale price to get the net sale price of the asset.
Back to previous page
|My official LSU home page||To LSU Department of Finance Home Page||To E. J. Ourso College of Business Administration Home Page||To LSU Home Page|
Last updated: January 9, 2011