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Chapter 6

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Capital Budgeting: Investing to Create Value

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Associated Press

Learning Objectives

A�er studying this chapter, you should be able to:

Describe the significance of corporate investments in crea�ng value.
Explain how iden�fying and classifying poten�al projects plays into project selec�on.
Es�mate project cash flows.
Show how to select independent projects using NPV and IRR.
Describe how to select mutually exclusive projects that maximize value.
Iden�fy the significance and different types of op�ons and how to adjust for the op�on effect.

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Ch. 6 Introduction

Throughout this text we have stressed the importance of crea�ng value for corporate shareholders. We also indicated that the greatest opportunity for crea�ng value lay in
the inves�ng ac�vi�es of companies. In the context of the financial balance sheet, these are le�-hand side ac�vi�es. The poten�al payoffs on successful investments prompt
ingenious efforts to develop new products, build exis�ng products at lower cost, improve product quality, and devise new marke�ng strategies. For example, the advent of e-
commerce allows small companies to sell products worldwide and large companies to supplement or possibly supplant tradi�onal distribu�on channels. E-commerce has, in
turn, spawned companies that design and manage websites, provide Internet services and make encryp�on so�ware.

Some product developments create virtually new industries. Consider the spectacular growth in wireless communica�ons that was made possible by the blending of satellite
and digital technologies. In an effort to gain a compe��ve advantage, network providers have expanded their coverage areas, improved transmission quality, added services,
and cut prices. Similarly, cell phone manufacturers embrace the latest in digital technology as they vie for market share.

In this chapter, we address the fundamentals of corporate inves�ng. First, we discuss product market opportuni�es created by imperfect compe��on. Next, we develop some
guidelines for iden�fying and selec�ng investment opportuni�es. We then examine the investment decision itself, paying special a�en�on to decision criteria and discounted
cash flows. Finally, we discuss op�ons that are intrinsic to many corporate investments.

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Shareholders must pay a�en�on to the product market when
deciding on investment opportuni�es because compe�tors can

6.1 Corporate Investments and Value Creation

We will draw upon several important ideas covered thus far in the text in our discussion of corporate inves�ng:

It is cash flows, not income or earnings, that measure the success of a business or investment.
The value of cash flows depends on when they are paid or received.
The effect of �ming on the value of future cash flow is incorporated into the discount rate.
The appropriate discount rate is the investors’ required rate of return.
This required rate of return is a func�on of risk.

Investors buy bonds and stocks that represent claims against future corporate cash flows. Corporate investments must, therefore, generate at least enough cash flow to
provide all investors with their required returns. If investments generate less than the required return, the value of the company’s securi�es—and, therefore, the value of the
company—will decline. Of course, investments are made in the hope that they will produce enough cash to pay off creditors with enough le� over to increase returns to
shareholders.

Investing in Fixed Assets

Depending on the industry, much corporate investment is in long-term, or fixed, assets. These assets can be classified as tangible (machinery, real estate) or intangible
(copyrights, patents, contracts). Tradi�onal capital-intensive industries invest in factories that manufacture durable goods, such as metals, chemicals, transporta�on
equipment, and machinery. However, virtually all companies, not just manufacturers, have fixed assets. Retailers either own or lease stores. R&D firms have laboratories and
patents. Book and music publishers have copyrights and, perhaps, long-term contracts with writers and musicians. One of the best-known assets is the secret formula for
Coca-Cola. Whether tangible or intangible, fixed assets are essen�al to the long-run viability of a firm.

Identifying Asset Value: NPV and IRR

The ability to iden�fy which assets are expected to add value to the firm is central to the financial management role. In this chapter, we explore this selec�on process (called
capital budge�ng) in some detail. Essen�ally, to iden�fy value-crea�ng projects, businesses use either the net present value (NPV) or internal rate of return (IRR) criteria.

Net present value measures the dollar value added to the firm by the investment. The NPV of an investment is the present value of the future cash flows minus the ini�al
investment.

Net present value = Present value of future cash flows –

Ini�al investment

NPV directly measures the present value of the cash flows a project is expected to generate. It then compares this value to the project’s cost. If the project value is expected
to exceed the cost, the project should be pursued.

The IRR criteria compares the IRR (expected return) for a project to the required return for investors, given the project’s risk. If the expected return exceeds that requirement,
then the project should be pursued.

We will look at the equa�ons for finding NPV and IRR later in this chapter. For now, it is important to know that companies can add value to the business and increase
owners’ wealth by pursuing posi�ve NPV projects, or project’s whose IRR exceeds its required return. With this objec�ve in mind, we will begin our discussion of corporate
investments.

Product Market Opportunities

The financial model of the corpora�on is based on the premise that product markets provide valuable investment opportuni�es for firms. Firms that iden�fy and exploit
these opportuni�es create value because they do what their shareholders individually cannot do. The search for investment opportuni�es occurs within the overall mission
and strategic plan of the corpora�on.

Investment opportuni�es are o�en short-lived because successful products a�ract compe�tors. For example,
the success of Starbuck’s coffee spawned many purveyors of specialty coffees and espresso, and BlackBerry was
supplanted by the iPhone a�er a few years of market dominance.

Compe��on, or the threat of compe��on, means that firms must not only remain alert for new opportuni�es
but also try to protect their exis�ng markets. For example, major airlines on occasion have used some�mes
illegal predatory pricing to discourage low-cost “no-frills” airlines from serving their hub ci�es. Even seemingly
entrenched firms may be vulnerable to compe��on. Before Japanese autos entered the market, the United
States was the nearly exclusive turf of the big three American automakers.

Firms have a number of weapons with which to fend off compe�tors. Patents and copyrights protect, for a
�me, valuable intellectual property, such as inven�ons, publica�ons, and computer so�ware. Some�mes
protec�ng a compe��ve posi�on requires investment. For example, McDonald’s a�empted to forestall
compe��on by being the first to buy choice restaurant loca�ons. Inves�ng in a modern plant may lower
produc�on costs or increase product quality. Some industries invest heavily in promo�on. Athle�c apparel
manufacturers engage in a frenzied compe��on to sign hot sports stars to expensive long-term contracts.

Seeking out and successfully pursuing valuable investments places great demands on management. There are
many poten�al hazards. Managers may fail to recognize opportuni�es, or they may chase opportuni�es that do

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quickly overshadow a leading product as demonstrated by iPhone’s
dominance over BlackBerry.

Associated Press

not exist. For example, a market may appear to be a�rac�ve because it produces extraordinarily high profits.
Yet a closer examina�on reveals that exis�ng producers hold patents on key technologies or may control supply
sources or distribu�on channels.

When an apparent investment opportunity reveals itself, managers should ask the following ques�ons:

If this is a genuine opportunity, why is there not greater compe��on in this market?
Are compe�ng products on the horizon that may reduce market demand?
Are there costly barriers to entry?
Is the current compe��ve posture likely to remain over the long haul?
Are market forces already at work to increase compe��on?
Will the corpora�on be able to protect its investment by keeping compe�tors at bay?

Taking reasonable precau�ons should actually encourage inves�ng by making poor investments less likely. Companies that have a record of successful inves�ng may be more
aggressive in searching for new opportuni�es than those that have experienced recent or costly failures.

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The compe��ve advantage with a commodity is generally the price.
Differen�a�on strategies, such as performance, customer needs, tailoring
products, flexibility, and trust also play major roles. What would you say is
the differen�a�on strategy for a company like Amazon or Target?

High-end retailers like Neiman Marcus focus on a differen�a�on
strategy that emphasizes style, quality, and service.

Associated Press

6.2 Project Selection

Each firm must develop a compe��ve strategy for exploi�ng market opportuni�es. The most common of these
strategies are cost leadership and differen�a�on. Low-cost producers can undercut their compe�tor’s prices;
Wal-Mart, for example, uses this strategy. On the other hand, a differen�a�on strategy may take many forms. A
company may offer higher quality, a func�onally dis�nct product, or be�er service. Among clothing retailers,
there are Nordstrom and Neiman Marcus (quality and service) and L. L. Bean (func�onally dis�nct).
Differen�a�on frequently prompts large investments in adver�sing. In 1999 CNET, Inc. launched a $100 million
ad campaign to promote their technology website, even though the investment would wipe out their posi�ve
cash flows. A firm’s compe��ve strategy determines where it looks for market opportuni�es. For example, Wal-
Mart would not be likely to focus on product quality and service if that jeopardized its posi�on as a cost
leader.

A firm’s compe��ve strategy guides its strategic planning. These strategic plans are then translated into
investments. The process of transla�ng plans into investments begins with iden�fying a set of poten�al
projects. This requires the following steps:

Step 1: Iden�fy possible projects that fit into the corporate strategic plan or mission.

Step 2: Classify projects by size and purpose so that management a�en�on can be directed to those that are most important.

Step 3: Eliminate or integrate projects that are in some way dependent on other projects.

Let’s look at these more closely.

Compe��ve Strategies

Identifying Potential Projects

Ideally, a company’s search for investment opportuni�es would transcend its tradi�onal products and markets. For example, a company doing business in the United States
may consider overseas markets. A bank might consider providing computer services. A manufacturer of industrial equipment might also consider making consumer products.

Classifying Projects

Companies o�en find it useful to categorize poten�al projects by their size and the company’s experience with such projects. Large projects, with which the company has
li�le experience, require careful scru�ny. An example of such a project would be an American company inves�ng for the first �me in a less-developed country. At the other
extreme are rou�ne investments such as replacing a worn-out machine. Management resources are finite. By confining the search to projects that fit the company’s mission
and then classifying them, management can direct its a�en�on to a rela�vely few, crucial projects.

Projects that may seem risky and deserving of great management scru�ny must be judged in the context of exis�ng company opera�ons. Table 6.1 provides a representa�ve
scheme for classifying projects according to the amount of management a�en�on required.

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Foreign investment is one example of a diversifica�on project. Today, it is
not only countries like the U.S. and Great Britain that are expanding
overseas; industrial pioneer, China, is inves�ng money into the crumbling
economy of the Congo. How does China’s involvement in foreign investment
impact compe��ve markets?

Table 6.1: Project types and management oversight

Project type Descrip�on Management a�en�on required Example

Replacement
projects

Update or upgrade exis�ng capacity. Senior management typically does not make
decisions on these rela�vely rou�ne investments.

Replacing worn-out or obsolete
machinery and equipment.

Expansion
projects

Used to expand exis�ng capacity, such
as adding new machinery or
equipment to increase output.

Require only moderate management scru�ny
because capacity expansion is a response to
increased or an�cipated demand.

Retailers lease larger facili�es or
open addi�onal stores.

Diversifica�on,
or dispersion,
projects

Add new products or new regions to a
company’s opera�ons.

Demands on management may vary, depending
on how related the new products or regions are
to exis�ng ones.

Ini�al overseas expansion of a
domes�c corpora�on (high level of
management a�en�on).
Inves�ng in freight cars to lease to
private carriers (lower level of
management a�en�on).

Chinese Investment in the Congo

There are two other investment categories that don’t fit neatly into a risk classifica�on. One is investment mandated by law, such as pollu�on control equipment to comply
with environmental regula�ons and plant improvements to conform to occupa�onal safety and health codes. The other is investment in other companies. Mergers and
acquisi�ons are risky in part because they combine corporate cultures. Most mergers expand exis�ng capacity, diversify product lines, or extend opera�ons to new regions.

Eliminating Project Dependencies

When we first iden�fy poten�al investments, we may include projects that are either complementary or mutually exclusive. Pipelines to bring crude oil to the refinery and
transport refined petroleum to ports or markets must accompany a new oil refinery. It makes li�le sense to evaluate the refinery separately from the pipelines. These are
complementary projects and should be considered a single investment.

Mutually exclusive projects are subs�tutes for each other, requiring either/or decisions. There may be alterna�ve types of pipelines that can be built to serve the oil refinery,
or rail cars or barges may be used in place of pipelines. The company must select the best op�on for each task and discard the others.

Once the company’s financial analysts have combined complementary projects and chosen among mutually exclusive projects, those that remain are independent projects.
Independent projects all have equal status, meaning that the company may invest in all, none, or any combina�on of projects, knowing that each investment decision does
not affect the others. This greatly simplifies the analysis and allows management to focus on the process of crea�ng wealth. As is usual in business, even though simplifying
assump�ons aids our analysis, we must deal at some point with less simple reali�es. In truth, individual projects must be viewed in the context of the por�olio of
investments.

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Purchasing new pipelines for a new oil refinery is an example of a
complementary project because they are interconnected. Can you
think of any other examples of complementary projects?

Hans-Peter Merten/Digital Vision/ Ge�y Images

6.3 Estimating Project Cash Flows

Once a company’s financial analysts have iden�fied an array of independent projects, they must evaluate each as a poten�al investment. First, they must es�mate cash flows
that are associated with the project. These include the ini�al investment, opera�ng income and expenses spread over the life of the project, and project termina�on.
Opera�ng and termina�on cash flows are discounted, and their present value is then compared to the ini�al investment. If the present value of the future cash flows is
greater than the ini�al investment, the investment has a posi�ve net present value. A posi�ve net present value indicates that the investment will add value to the company.

Recall from Sec�on 6.1 that

Net present value = Present value of future cash flows – Ini�al investment

In order to calculate net present value, we must es�mate the amount and �ming of the investment’s cash flows. In this sec�on, we provide some ground rules for es�ma�ng
cash flows and then show how they are used in a discounted cash flow model.

Consider Only Incremental Cash Flows

The most difficult part of project analysis is iden�fying and quan�fying cash flows related to the project. Here, the guiding principle is to include only incremental cash flows,
defined as the change in corporate cash flows a�ributable to the project. This seems simple enough, but these cash flows can be elusive. Even the cost of some projects may
be impossible to pin down. Consider how difficult it is to es�mate the completed cost of an office building or plant that may take years to complete. Some cash flows may
escape a�en�on altogether, such as the effect of one project on another project’s cash flows. Here are a few guidelines for iden�fying incremental cash flows:

Beware of allocated costs, such as corporate overhead. Usually allocated costs do not change as a result of taking on projects. For example, a new project may use exis�ng
idle capacity on the company’s computer network. Assuming that there is no alterna�ve use for the network capacity and support staff, there is no incremental cost. So
nothing should be allocated to the new project. On the other hand, the project’s demand for network services may compel the company to add capacity. In this case, the
cost incurred is incremental and should be included in the project.
Consider the opportunity costs of currently owned resources. Take for example, a plant built on land owned by the company. The land entails no out-of-pocket costs;
however, it is not a free resource because it has alterna�ve uses. The analyst must consider, as the cost of the land, the income that could be produced from its next-best
use. Perhaps it could become a parking lot, be sold, be leased, or be used for growing tomatoes.
Ignore sunk costs. A sunk cost is money that has already been spent and cannot be recovered. However, it can be difficult (on many levels) to abandon projects on which
a great deal of money has been spent. Abandonment has its own costs, and some�mes finishing a project that may have been unwise to begin with is the only way to
recover at least some of its costs. The analyst must consider the incremental costs and revenues of comple�ng a project.
Consider incidental effects of the project. A new product may reduce sales of other company products. For example, a retailer that opens a second loca�on in the same
town will lose some customers to the new store. There may be posi�ve incidental effects as well. For instance, large airlines subsidize small feeder airlines to deliver
passengers to and from their hub airports. For the feeder airlines, these incidental effects make them viable. Iden�fying and cos�ng all incidental effects of a project is
easier said than done. Projects that depend on incidental effects may be very risky and should be taken on with cau�on.

Cash Flow Categories

It is convenient to categorize project cash flows by their �ming, that is, when they occur. The ini�al investment occurs at the beginning of the project’s life, opera�ng income
and expense are annual cash flows occurring during the project’s life, and termina�on cash flows occur when the project ends. Each category includes cash flows from
different sources. Figure 6.1 outlines these categories, and they are discussed in further detail below.

Figure 6.1: Cash flow categories over a project’s life�me

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Project cash flows can be categorized across the life of the project. Ini�al investment cash flows occur at the
beginning of the project’s life, opera�ng income and expense flows occur during the project, and termina�on
cash flows occur at the end of the project.

Wages for employees are a cash ou�low
opera�ng expense. What addi�onal
examples of opera�ng expenses can you
think of?

Jus�n Guariglia/Na�onal Geographic Stock

Ini�al Investment

Project cost (cash ou�low) may include transporta�on, insurance, setup, employee training, and prepaid maintenance. For some projects, it may also include infrastructure
costs such as roads and u�li�es. Also included may be planning and design costs such as architectural fees. Be careful to not include sunk infrastructure, planning, and design
costs. For simple projects, the ou�low occurs at the present �me (t = 0). However, large projects, such as plant construc�on, may take several years to complete.

Investment tax credits (cash inflow) reduce taxes paid in some propor�on to the project cost. From �me to �me, governments provide tax credits for certain kinds of
investments. Currently, there is no general investment tax credit ( ITC) in the United States, but there are ITCs in other countries.

Change in net working capital (cash ou�low or inflow) may be required by expansion, diversifica�on, and dispersion projects. Increased inventories and receivables may be
needed to support increased produc�on. These current assets are �ed to the investment and are therefore incremental costs. Generally, we assume that this increased
working capital is reduced to its prior level on termina�on of the project, resul�ng in a decrease, or recovery of net working capital. Some investments may actually reduce
the need for net working capital. For example, a new produc�on facility may employ just-in-�me inventory control, reducing the need for inventory stocks.

Sale of exis�ng asset (cash inflow) generally occurs only for replacement projects.

Tax effect of asset sale (cash inflow or ou�low) must be considered when the sale price of the asset is greater than its depreciated book value and the company owes tax on
the difference. If the sale price is less than the book value, the loss reduces the company’s taxable income.

Opera�ng Income and Expense

Opera�ng income and expense are annual revenues and expenses occurring during the opera�ng life of the project. Of the three
categories, the incremental cash flows associated with opera�ons are the most difficult to iden�fy.

Cash revenues (cash inflow) include sales and other incidental income. These cash flows are usually not an annuity because unit sales
and prices will not be constant from year to year.

Cash expenses (cash ou�low) include materials, labor, fuel or power, maintenance, rents, contract services, and any number of other
incremental costs. As with sales, they normally vary from period to period. Replacement projects may reduce expenses, producing
cash savings. These are all opera�ng expenses and do not include interest or other capital costs. Costs of capital are included in the
discount rate.

Deprecia�on (cash inflow) of fixed assets is noncash, tax deduc�ble expense. The tax saving is the only cash flow resul�ng from
deprecia�on. For a replacement project, only the change in deprecia�on between the new and old projects is relevant.

Project Termina�on

Income from project sale (cash inflow) results from assets that have economic value beyond the life of the project. They may be sold
intact, in parts, or as scrap. Companies o�en plan to resell assets a�er a specified period. Their resale or terminal value may add
significantly to a project’s value.

Tax effect of project sale (cash inflow or ou�low) is treated in the same way as that on the sale of an exis�ng asset.

Recovery of net working capital (cash inflow or ou�low) occurs at the termina�on of a project, when the ini�al change in net working
capital is reversed in order to return to the original net working capital posi�on.

Cash Flow Calculations

Now, we look at specific calcula�ons for two types of project cash flows.
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The Tax Effect of Asset Sales

If an asset is sold for more than its depreciated book value, the difference between the sale price and book value is a taxable capital gain. The tax that must be paid equals
the gain �mes the marginal corporate tax rate. A capital loss resul�ng from a sale price less than book value reduces the company’s tax, assuming that it has other taxable
income. The tax treatment of asset sales applies to both ini�al investment and termina�on cash flows. To illustrate, consider a project in which exis�ng equipment is to be
replaced by new equipment cos�ng $10,000 (shown in Table 6.2). The exis�ng equipment may be sold for $3,000, but it has a depreciated book value of $2,500, crea�ng a
$500 taxable gain on the sale. The tax rate is 34%. Cash flows are starred (*).

Table 6.2: Tax effect of asset sale

Data Category Value

*Project cost ($10,000)

*Sales price of exis�ng asset $3,000

Book value of exis�ng asset $2,500

Gain (Loss) $500

Tax effect of sale (gain x tax rate) ($170)

To determine the ini�al cash flow, we add the tax effect to the project cost and sale price:

Ini�al cash flow = Project cost + Sale price + Tax effect

Ini�al cash flow = (10,000) + 3,000 + (170) = ($7,170)

Some or all of the gain on an asset sale actually represents the recapture of deprecia�on. If the tax rate on capital gains and losses is the same as the tax rate on income,
the source of the gain is immaterial. However, if the capital gain tax rate is less than that on ordinary income, then deprecia�on recapture must be calculated and the
appropriate tax rate applied.

Opera�ng Cash Flows

The es�mates of annual opera�ng income and expenses must be converted to opera�ng cash flows. This is done using the net income approach to calcula�ng cash flows.

Step 1: Calculate taxable income. Earnings before tax (EBT) equal cash revenues minus opera�ng expenses and deprecia�on.

EBT = S – E – dep

Step 2: Calculate corporate income tax. Corporate tax is the product of EBT and the marginal corporate tax rate (tx).

Step 3: Calculate net income or earnings a�er tax (EAT) by subtrac�ng the tax from the EBT. The final step is to calculate opera�ng cash flow (OCF) by adding deprecia�on to
net income.

OCF = EAT + dep

Project cash flows and the calcula�on of opera�ng cash flow are summarized in Table 6.3.

Table 6.3: Classifying project cash flows

Cash flow Classifica�on

Ini�al investment

Project cost Ou�low

Investment tax credit Inflow

Change in net working capital Ou�low/inflow

Sale of asset Inflow

Tax effect of sale Ou�low/inflow

Opera�ng cash flows

Cash revenues (S) Inflow

Cash expenses (E) Ou�low

Deprecia�on (dep) Noncash expense

Tax Ou�low

Calcula�ons for opera�ng cash flows
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Earnings before tax (EBT) S – E – dep

Corporate tax EBT × tx

Earnings a�er tax EAT = EBT − tax

The Challenge of Estimating Project Cash Flows

These guidelines for es�ma�ng project cash flows do not capture the difficulty of actually gathering informa�on and producing es�mates. A single independent project may
include building a plant, installing produc�on equipment, buying trucks, and training workers. Such a project involves gathering and si�ing large quan��es of informa�on.
Incomplete or inaccurate informa�on may lead to an incorrect decision. The large amounts of capital required by many projects make the cost of incorrect decisions that
much greater.

Some cash flows, such as equipment costs and taxes, are rela�vely easy to es�mate because their costs are explicit. Future cash flows that are dependent on the success of
the project require more sophis�cated and �me-consuming es�mates. Table 6.4 divides project cash flows into two categories: those that are fairly easy to es�mate and
those that are more difficult. Keep in mind that these categories are guidelines only, not absolutes.

Table 6.4: Es�ma�ng project cash flows

Step in project life cycle Less difficult to es�mate More difficult to es�mate

Ini�al investment Project cost
Investment tax credit
Sale of exis�ng asset
Tax effect of asset sale

Change in net working capital

Opera�ng cash flows Deprecia�on Cash revenues
Expenses

Project termina�on Income from sale of project
Tax effect of project sale
Recovery of net working capital

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6.4 Selecting Independent Projects

As discussed earlier, independent projects are those that do not affect a company’s other projects. Once an independent project has been iden�fied, we must determine
whether or not it is a worthwhile endeavor. Recall that net present value plays a key role in project selec�on by determining expected cash flows.

An independent project should be taken if its NPV is posi�ve (NPV > 0). NPV is a direct measure of the project’s contribu�on to firm value. Even projects with small NPVs
should be taken, at least in principle. Any posi�ve NPV project is expected to produce a cash flow in excess of that needed to provide investors with their required rates of
return. Cash flow from a project whose NPV = 0 should provide these required returns; however, it would produce no residual cash flow to increase shareholder wealth.
Therefore, shareholders would be indifferent toward the project.

Next we will examine the equa�ons used to calculate net present value and internal rate of return for an independent project.

Calculating NPV and IRR for Independent Projects

Recall that net present value is equal to present value of future cash flows minus the ini�al investment (NPV = PV – II). Present value (PV) is the summa�on of the
discounted opera�ng cash flows (OCF) plus the discounted terminal cash flows (TCF). The formula for calcula�ng NPV is

Table 6.5 breaks down the components of Equa�on (6.1) and Equa�on (6.2).

Table 6.5: Variables in NPV and IRR equa�ons

Variable Value

II Ini�al investment

OCFt Opera�ng cash flows in year t

TCF Terminal cash flows

t Year

N Life span (in years) of the project

R(r) Project required rate of return

Remember that internal rate of return is the expected rate of return on a project. IRR is found by solving for the discount rate that equates the present value of future cash
inflows to the project cost. To calculate IRR, we use trial and error to find the discount rate that sa�sfies the condi�on PV = II, which is equivalent to NPV = 0. Solving for a
project’s IRR is the func�onal equivalent of solving for a bond’s yield to maturity.

For a single future cash flow or a mul�ple period annuity cash flow, IRR can be solved algebraically. However, project cash flows are seldom annui�es, leaving us no choice
but to find IRR through trial and error. This is a tedious process without the assistance of a calculator or computer.

The formula for IRR is

Comparing NPV and IRR Results on Independent Projects

If a project is found to have a posi�ve net present value, it will also have an internal rate of return greater than its required rate. On the other hand, if the project NPV is
found to be nega�ve (less than 0), then the IRR would also be less than the required rate of return. Symbolically, the rela�onship between NPV and IRR may be stated

If NPV > 0, then IRR > R(r).

If NPV = 0, then IRR = R(r).

If NPV < 0, then IRR < R(r).

Although IRR does not directly measure the project’s contribu�on to firm wealth, we see the equivalency of NPV and IRR decision rules (if NPV > 0, then IRR > R(r), etc.). This
equivalency leads to an important point: For independent projects, both NPV and IRR analyses will cause us to accept and reject the same projects. Therefore, it does not
ma�er which method of analysis we choose. Both use discounted cash flows and the required rate of return in the investment decision. Net present value uses the required
rate of return as a discount rate and produces a dollar value for the project; IRR uses the required return as a hurdle rate, or reference point against which to compare the
project’s internal rate of return.

Now, let’s apply what we have learned about determining project value.

Application: The Pogo Harness Project

Nine years ago, engineer Paula Bauer founded Pacific Offshore Ltd. (POL) as a supplier of high-quality hardware and gear for sailboats. Five years ago, a successful ini�al
public offering of stock provided the capital POL needed to meet demand and expand its product line. Paula is most directly involved in product development and is always
looking for ideas that can be turned into new products for the sailor. She o�en sails with her dog Pogo. A�er having to fish Pogo out of the water on several occasions, Paula

Processing math: 0%

While the Pogo harness could be considered a product sailors will
use, it is essen�ally an independent project as POL’s investment in
it does not affect any other company product.

ZUMA Press/Corbis

recognized the need for a harness that would keep Pogo on board yet give the dog some freedom to move
about the boat. Paula and her vice president, Sonny Wheeler, designed and tested a harness that met with
Pogo’s approval.

Paula and Sonny calculate that they can produce the harness and associated hardware with an investment of
$57,000 in tools and equipment. Alterna�vely, they could invest about $225,000 in automated, high-speed
machine tools that would greatly reduce unit produc�on costs at higher produc�on volume. Because the Pogo
harness is an untested product, they opt for the lower investment. It will cost an addi�onal $11,000 to slightly
alter their manufacturing facility to handle this new product. Increased sales from the Pogo harness project
should increase average receivables and inventory from $23,000 to $25,000. Distribu�on will be handled
through normal catalog and chandlery sales, but they also plan to market through pet supply stores, and the
Pogo harness will be featured on POL’s new website. Paula and Sonny agree that they will push ahead with the
website even if they decide to not produce the Pogo harness. The reconfigura�on of the manufacturing facility
will allow POL to sell some older equipment for an es�mated $7,800.

Paula es�mates that the Pogo harness will produce cash flows for five years. A�er five years, if demand
warrants, she will invest in automated equipment to cut produc�on costs. If there is insufficient demand or if
lower-cost compe�tors have flooded the market, she will cease produc�on. Either way, POL will no longer need

the exis�ng tools. Paula’s produc�on manager es�mates that the rather specialized tools will bring no more than $12,000 when they are sold in five years. Tools, equipment,
and reconfigura�on costs are depreciated on a seven-year accelerated cost-recovery schedule. Pacific Offshore’s effec�ve tax rate on income is 34%, and its tax rate on capital
gains is 28%. The projected cash flows for the Pogo harness project are shown in Table 6.6 and Table 6.7.

Table 6.6 presents data on the sale of the exis�ng equipment and the sale in Year 5 of the tools of the Pogo harness project. All project cash flows, including opera�ng cash
flows, are shown in Table 6.7.

Table 6.6: Pogo harness project: Calcula�ng the tax effect of asset sales

Data Category Cash Value

Sale of exis�ng equipment (Year 0)

Book value (book) $0

Sale price (sale)* 7,800

Capital gain or loss (gain) 7,800

Tax effect of sale (gain) × (tax)* 2,184

Sale of Pogo harness project tools (Year 5)

Original purchase price $57,000

Book value (book)** 12,717

Sale price (sale)* 12,000

Capital gain or loss (gain) (717)

Tax effect of sale (gain) × (tax)* (201)

* Designates cash flow
** At the end of Year 5, accumulated deprecia�on totals 77.69%
Book value = $57,000 x (1 – 0.07769) = $12,717
Capital gain tax rate = 28%

Table 6.7: Pogo harness project: Cash flows

Cash Flow Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

Ini�al investment

Tools and equipment ($57,000)

Plant reconfigura�on ($11,000)

Added net working capital ($2,000)

Sale of asset $7,800

Tax effect of sale $2,184

Total ($64,384)

Opera�ng cash flows

Cash revenues (S) $42,500 $49,300 $55,216 $60,185 $65,602Processing math: 0%

Expenses (E) $29,750 $29,580 $33,130 $30,093 $32,801

Deprecia�on (Dep) $9,717 $16,653 $11,893 $8,493 $6,072

Earnings before tax
(EBT = S – E – dep)

$3,033 $3,067 $10,193 $21,600 $26,729

Tax (tax=0.34)
(EBT x tax)

$1,031 $1,043 $3,466 $7,344 $9,088

Earnings a�er tax
(EAT = EBT – tax)

$2,002 $2,024 $6,728 $14,256 $17,641

Add back deprecia�on
(EAT + Dep)

$11,719 $18,677 $18,621 $22,749 $23,713

Project termina�on cash flow

Income from sale $12,000

Tax effect of sale $201

Recovering net working capital $2,000

Total $14,201

Annual deprecia�on rate 14.29% 24.49% 17.49% 12.49% 8.93%

Calcula�ng the NPV and IRR for the Pogo Harness Project

The Pogo harness project’s cash flows are summarized in Table 6.8. Pacific Offshore’s required rate of return on investments is 12.5%. For our analysis, this required return
(R(r)) is given. In Chapter 7 we will show how to es�mate the required rate of return for a project.

Table 6.8: Pogo harness project cash flow summary

Cash Flow Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

Ini�al investment ($64,384)

Opera�ng cash flows $11,719 $18,677 $18,621 $22,749 $23,713

Ending cash flows $14,201

Cash flows ($64,384) $11,719 $18,677 $18,621 $22,749 $37,914

Present value ($64,384) $10,417 $14,757 $13,078 $14,202 $21,040

NPV $9,110

IRR 17.2%

Required rate of return 12.5%

Using the data given, we can expand Equa�on (6.1) to determine the project’s NPV:

The NPV indicates that the harness project will add $9,110 in value to the company if our cash flow es�mates are correct and if 12.5% is the appropriate required rate of
return. Note that the cash flow in Year 5 is the sum of the opera�ng cash flow and termina�on cash flow ($23,713 + $14,201).

Now, let’s solve for the IRR for this project.

Solving for the discount rate, the IRR for the Pogo harness project is 17.2%. This is the rate that equates the present value of the cash flows in Years 1 through 5 to $64,384.

Comparing NPV and IRR Results for the Pogo Harness Project

As we discovered in our calcula�ons above, the IRR for the Pogo harness project is greater than its required rate of return (17.2% > 12.5%), making it a worthwhile project
for the company to pursue. If Pacific Offshore Ltd. chooses to invest in the project, it will add $9,110 to the value of the company. Stated another way, if it does not take on
the project, it will have missed an opportunity to increase firm value by that amount.

The rela�onship between NPV and the discount rate is worth exploring further. Figure 6.2 plots the NPV of the Pogo harness project at various discount rates. One of the
discount rates is the IRR, which is 17.2%. The IRR of 17.2% is the point at which NPV = 0. (This is where the line crosses the x-axis.) Note that at discount rates less than
17.2%, NPV is posi�ve, while rates above 17.2% yield nega�ve NPVs.

Figure 6.2: Pogo harness project NPV at various discount rates
Processing math: 0%

The NPV of a project declines if the project has a higher required return.

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A city that wants an upgraded stadium must decide whether to
renovate or build anew. This is an example of a mutually exclusive
project.

Ge�y Images News/Ge�y Images

6.5 Selecting Mutually Exclusive Projects

With the Pogo harness project, we saw that both NPV and IRR will lead to the correct accept or reject decision. The harmony between NPV and IRR exists because the Pogo
harness project is independent. When projects are not independent, the harmony between NPV and IRR breaks down. There are primarily two types of project dependency:
mutually exclusive projects and limited capital budget (capital ra�oning). In each case, acceptable projects (i.e., those with NPV > 0 and IRR > R(r)) must compete against one
another. This implies that some acceptable projects will not be taken. In this sec�on we deal with mutually exclusive projects.

Mutually exclusive projects compete with others, all of which are acceptable using NPV and IRR decision rules.
The analyst must choose the best of these projects and discard the rest. In most cases, both NPV and IRR will
iden�fy the same best project; that is, the project with the highest NPV will also have the highest IRR.
However, the analyst watches for condi�ons under which NPV and IRR disagree:

The �ming of cash flows differs substan�ally between projects. For example, most cash flows for one
project occur early in its life, while those for another project occur late in its life.
Projects are of substan�ally different size, meaning that one requires a much larger investment than the
other.

Timing of Project Cash Flows

Let’s look at four mutually exclusive projects to see how �ming of cash flows impacts the accord between IRR
and NPV.

Table 6.9 shows cash flows, IRR, and NPV for mutually exclusive projects A–D. The required rate of return, R(r),
equals 10%. The �ming of cash flows differ over the six-year period.

Table 6.9: Mutually exclusive projects with different �ming of cash flows

Project Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 NPV at 10% IRR

A ($9,000) $2,400 $2,400 $2,400 $2,400 $2,400 $2,400 $1,453 15.3%

B ($9,000) $500 $500 $2,000 $2,000 $6,000 $6,000 $1,849 14.6%

C ($9,000) $1,700 $1,700 $1,700 $1,700 $1,700 $1,700 ($1,596) 3.4%

D ($9,000) $5,000 $5,000 $1,000 $1,000 $300 $300 $1,468 19.4%

Both NPV and IRR indicate that project C is not acceptable; therefore, we can concentrate on the remaining three projects. Project A is an annuity, project B’s cash flows
occur mostly in the later years, and project D’s cash flows occur mostly in the early years. No�ce that the project with the late cash flows (B) has the highest NPV, and the
project with the early cash flows (D) has the highest IRR. Project A, the annuity, has neither the highest NPV nor the highest IRR. Projects A, C, and D all have IRR greater
than the R(r) of 10%; this means that they could all be considered acceptable projects, because their IRR > R(r).

Why does �ming of cash flows lead to conflicts between NPV and IRR? Because, for acceptable projects, NPV discounts cash flows at a lower rate, R(r), than does IRR. This
affects project selec�on because discount rates are also compounding rates of return.

In general, IRR favors projects whose cash flows occur mostly in the early years. NPV, which is less affected by compounding because of its lower discount rate, does not
favor projects with early cash flows. NPV favors project B with its greater dollar cash flows, even though they occur in the later years. Although this may seem like a technical
triviality, it is not if it causes disagreement between NPV and IRR.

Differences in Size of the Initial Investment

Now, let us look at four mutually exclusive projects to see how a different size in ini�al investment disrupts the harmony between IRR and NPV.

Table 6.10 shows the ini�al investment, cash flows, NPV, and IRR for mutually exclusive projects E–H. As in the previous example, the required rate of return, R(r), equals
10%.

Table 6.10: Mutually exclusive projects with different ini�al investments

Project Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 NPV at 10% IRR

E ($5,000) $1,800 $1,800 $1,800 $1,800 $1,800 $1,800 $2,839 27.7%

F ($10,000) $3,300 $3,300 $3,300 $3,300 $3,300 $3,300 $4,372 23.9%

G ($15,000) $4,500 $4,500 $4,500 $4,500 $4,500 $4,500 $4,599 19.9%

H ($20,000) $5,700 $5,700 $5,700 $5,700 $5,700 $5,700 $4,825 17.9%

We see that the largest project (H) has the largest NPV. We expect larger projects to produce greater value. Conversely, the smallest project (E) has the highest IRR. In
general, lower-cost investments tend to have higher IRR. If two investments have equal cash flows, the investment that costs the least must have the highest rate of return.Processing math: 0%

Resolving the Conflict: Choosing NPV Over IRR

Most of the �me, an analyst will not be faced with having to resolve a conflict between NPV and IRR. Conflicts are irrelevant if projects are independent. For mutually
exclusive projects, conflicts are likely only when there are substan�al differences in �ming of cash flows or differences in project size. When conflicts arise, there are three
reasons for choosing NPV.

Reason 1: The Rate of Return. For acceptable projects, NPV assumes that project cash flows are compounded at the required rate of return, whereas IRR assumes that cash
flows are compounded at a higher rate [IRR > R(r)]. Consider project D in Table 6.8 with its IRR of 19.4%. This project generates a $5,000 cash flow in Year 1 of a six-year life.
The IRR method implicitly assumes that this $5,000 is invested at 19.4% for the remaining five years. The NPV method, on the other hand, assumes that the $5,000 is
invested at 10% over the same period. Unless the company has other investment opportuni�es that yield close to 19.4%, it is more prudent to assume that the project cash
flows will earn about 10%, which represents the company’s opportunity cost.

Reason 2: Value Crea�on. NPV is a direct measure of value. For example, project H in Table 6.9 is expected to add $4,825 in value to the company, whereas project E, which
has the highest IRR, will add only $2,839 in value.

Reason 3: Mul�ple IRRs. The cash flows for all investments follow the same basic pa�ern: An ini�al investment is followed by cash inflows, usually over a number of years.
Some�mes the ini�al investment may last for a number of years before the cash inflows begin. For most projects, once the cash inflows begin, they con�nue un�l the project
is terminated. However, there are cases where a project may require a midlife investment. A planned upgrade of a plant or equipment would be an example. The cash flow
pa�ern of such an investment is shown in Table 6.11.

Table 6.11: Sample cash flow for project with midlife investment

Year Cash flow (+ or –)

1 –

2 +

3 +

4 +

5 –

6 +

7 +

With this or any similar cash flow pa�ern involving more than one sign change, there is more than one discount rate that renders NPV = 0. Therefore, the project has more
than one IRR. For such projects, the calculated IRR is unreliable, and IRR should be abandoned in favor of NPV.

Payback as an Alternative to NPV and IRR

Before electronics gave us a hand in making complex calcula�ons, payback was the most common means of evalua�ng a project. Payback period is simply a measure of how
many years it takes a project to recoup its ini�al investment. Table 6.12 compares the payback period for projects A–D from Table 6.9 with their NPV and IRR.

Table 6.12: Comparing payback to NPV and IRR for mutually exclusive projects

Project Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Payback Years NPV at 10% IRR

A ($9,000) $2,400 $2,400 $2,400 $2,400 $2,400 $2,400 3.75 $1,453 15.3%

B ($9,000) $500 $500 $2,000 $2,000 $6,000 $6,000 4.67 $1,849 14.6%

C ($9,000) $1,700 $1,700 $1,700 $1,700 $1,700 $1,700 5.29 ($1,596) 3.4%

D ($9,000) $5,000 $5,000 $1,000 $1,000 $300 $300 1.8 $1,468 19.4%

The calcula�on of payback is quite simple. Project A in has an ini�al investment of $9,000, and its inflows are outlined in Table 6.13.

Table 6.13: Project A cash inflows

Year Cash flow Cumula�ve cash inflow

1 $2400 $2400

2 $2400 $4800

3 $2400 $7200

4 $2400 $9600

5 $2400 $12000

6 $2400 $14400Processing math: 0%

The benefit of simple calcula�on is no
longer a viable reason to use payback
rather than NPV and IRR as advanced
so�ware and calculators now do the work
for you.

PR Newswire/Associated Press

From the cumula�ve cash flow column, we see that the $9,000 will be returned some�me during the fourth year. Through
interpola�on, we determine that payback occurs three-quarters of the way through the fourth year, making the payback period
3.75 years. Payback periods for projects B–D are similarly calculated.

Payback’s single virtue is that it is easily calculated. However, payback has some serious short-comings. First, we have not
discounted future cash flows, so the �me value of money is ignored. This flaw could be overcome by calcula�ng a payback period
using discounted annual cash flows. Discoun�ng complicates the calcula�on, elimina�ng payback’s most basic virtue. Payback also
disregards cash flows occurring a�er the payback period. Project D’s payback is 1.8 years, yet the project produces cash flows for 4
more years. If the last 4 years of Project D’s cash flows were to disappear, its payback would remain at 1.8 years although the
project’s value would have diminished.

No�ce in Table 6.12 that projects with the lowest payback period are those with the highest IRR. This is because both payback and
IRR favor projects with large early cash flows. If we are seeking projects with the greatest NPV, payback leads us down the wrong
path. No�ce also that we cannot automa�cally exclude project C, which has a payback of 5.29 years. Project C is unacceptable
because of its nega�ve NPV and IRR, which is less than the 10% required return. However, we do not know whether 5.29 years is
an unacceptably long payback period. This absence of a defini�ve criterion for accep�ng or rejec�ng a project is yet another failing
of payback. Ease of calcula�on is not a compelling enough reason to use payback in the age of electronics.

Processing math: 0%

Op�ons are more familiar than you would think, as coupons are a
type of op�on. Can you think of any other examples of everyday
op�ons?

PR Newswire/Associated Press

6.6 Options in Capital Projects

To most people, op�ons are synonymous with stock op�ons, which are contracts that investors buy and sell in the op�ons market. Stock op�ons have become big news in
recent years because they are o�en a major part of the compensa�on of execu�ves and employees. In this sec�on, we describe op�ons, explain why they are valuable, and
iden�fy op�ons that are associated with capital projects.

Characteristics of Options

All op�ons have certain features in common. First, they give the holder the right to buy or sell valuable assets at some future �me. Some, like call op�ons, specify the price
and �me period in which the asset can be purchased. Other op�ons give the holder the right to perform a certain ac�on. For example, a company may contract with a labor
union for an op�on to lay off factory workers temporarily during cyclical reduc�ons in demand for its product. The company holds a put op�on, which is the right to sell or
rid itself of unneeded labor (an asset). In return, the union may extract concessions from the company in the form of job security or compensa�on. A second feature of
op�ons is that they do not bind the holder to buy or sell. The holder will only exercise the op�on when it is in his or her interest (i.e., it is profitable to do so). A third
feature of op�ons is that the seller must honor the terms of the op�on when the holder chooses to exercise it. Many op�ons, however, carry specific expira�on dates. Once
the date has passed, the op�on has no more value than an expired lo�ery �cket, and the seller is no longer required to honor the terms.

There are two prices associated with op�ons. The first is the price paid by the buyer. This could be in the form of cash, concessions, or some other form. The second is the
price paid when the holder exercises an op�on to buy an asset. It may also be the price received when the holder of a put op�on exercises an op�on to sell. The price paid
on a call op�on or received on a put op�on is called the exercise price.

An Option Example

You may be more familiar with op�ons than you realize. Consider a pizza coupon. Suppose The Pizza Company offers a coupon that gives you the right to buy their famous
Kitchen Sink pizza that normally sells for $13.99 for $9.99, however, you must use it by November 15. This coupon is an example of a call op�on contract. The valuable asset
is the pizza, the exercise price is $9.99, and the expira�on date is November 15.

Another familiar example involves buying a house. A buyer makes an offer on a house for $200,000. The buyer accompanies the offer with an earnest money check for
$2,000. This earnest money is the price of a call op�on on the house, effec�vely taking the house off the market and giving the buyer a few days to reconsider and arrange
financing. The buyer may then exercise her op�on to buy the house for the exercise price of $200,000. If she chooses not to buy, she loses her earnest money.

The cost of the op�on on the home is explicit, $2,000. The pizza coupon is nominally free, but there is a cost (at least The Pizza Company hopes there is a cost). If you were
going to buy a Kitchen Sink pizza without the coupon, then The Pizza Company has lost the difference between the regular price and the coupon price. On the other hand,
you may be tempted to visit The Pizza Company instead of your regular pizza parlor and try a Kitchen Sink pizza. If you like it, you could become a regular customer of The
Pizza Company. If you don’t, you paid only $9.99 for the pizza.

We exercise a call op�on when the value or price of the asset exceeds the exercise price. Obviously, the pizza
coupon would be worthless if you could buy the pizza for $9.99 or less without the coupon. Conversely, we
exercise a put op�on (to sell) if the exercise price exceeds the value of the asset. O�en a put op�on can be
thought of as the opposite of a call op�on. For example, if The Pizza Company thought that it could sell all the
pizzas it could make at $13.99, it would not offer the coupon. It offers the coupon because selling pizza for
$9.99 is be�er than selling it for a lower price, giving away free pizza, or losing inventory through spoilage.

It is important to note that, because op�ons do not have to be exercised, they can never have a nega�ve
value. Op�ons are exercised only when they have value to the holder; otherwise, they simply expire. This is not
to say that an investor cannot lose money by buying an op�on. If you pay $100 for an op�on that ul�mately
proves to be worthless, you will not exercise the op�on, and you will have lost $100. If the op�on has a value
of $50, you will exercise it, losing only $50. This is an important point. If the op�on has any value at all, it
should be exercised. Doing so will at least cut your loss. Next, we examine the five factors that make op�ons
valuable.

Factors That Affect the Value of an Option

Let’s begin by examining two of the factors that make op�ons valuable. The first is the value of the op�oned
asset. The second is the exercise price. Op�ons gain value as the difference between the asset value and
exercise price widens. For a call op�on, this will occur if the asset value rises or the exercise price falls.
Returning to The Pizza Company example, if the normal price of the pizza rises to $15.99 from $13.99, the
coupon rises in value by $2.00. At $13.99, the $9.99 coupon saves you $4.00. At $15.99, it saves you $6.00. If
The Pizza Company offers another coupon for a Kitchen Sink pizza at $8.99, this coupon would be worth $1.00
more than the $9.99 coupon because the savings on a $13.99 pizza would rise from $4.00 to $5.00. If there
were a market for pizza coupons, their minimum value would equal the amount of the savings, which is the
market price minus the exercise price. It is possible that the value could be greater, depending on whether
pizza prices were expected to rise.

Summarizing the first two factors that affect op�on value:

1. All else being equal, as an op�on’s exercise price goes down, the value of a call op�on increases.Processing math: 0%

2. All else being equal, the higher the price of the underlying asset is, the higher the value of a call op�on will be.

Note as well that the coupon might have value even if the current promo�onal price of a pizza were less than the coupon price. The coupon has value, for example, if it does
not expire for a month, during which �me there is a reasonable chance that the price of pizza will rise above the coupon price. Now, suppose that the coupon will expire
tomorrow. It is unlikely that the promo�on will end by tomorrow. In that case, the coupon is essen�ally valueless. Time to expira�on, therefore, is another factor affec�ng
op�on value:

3. All else being equal, as the �me to expira�on increases, the value of a call op�on increases.

Consider a situa�on in which pizza prices are highly variable because of a shortage of mozzarella cheese. When The Pizza Company has to pay a premium for cheese, the
price of the Kitchen Sink pizza may rise to as much as $19.99. The possibility of prices greater than $13.99 makes the coupon even more valuable. People will conserve their
coupons when the price is $13.99 to use when the price is $19.99. At prices above the exercise price, the savings—and hence the value of the coupon—increases dollar for
dollar. At $19.99, the coupon is worth $10.00 ($19.99 – $9.99). When the price is $13.99, the coupon is nominally worth $4.00; however, with the price of pizza almost
certain to rise above $13.99, people are willing to pay more than $4.00 for a coupon. Price vola�lity of the asset, therefore, is another factor affec�ng op�on value.

4. All else being equal, the more vola�le the price of the underlying asset is, the more valuable the op�on will be.

The final factor that affects op�on value relates to the �me value of money lessons we learned earlier in this text. In effect, op�ons allow us to defer payment, and because
money has �me value, this deferred payment adds value to the op�on. The �me value of the deferred payment increases with the interest rate.

5. All else being equal, as interest rates rise, the value of op�on contracts will also increase.

Table 6.14 summarizes the five factors that affect the value of op�ons.

Table 6.14: Factors affec�ng the value of call op�ons

Factor 1 As an op�on’s exercise price goes down, the value of a call op�on increases.

Factor 2 The higher the price or the underlying asset, the higher the value of a call op�on.

Factor 3 As the �me to expira�on increases, the value of a call op�on increases.

Factor 4 Higher vola�lity of the price of the underlying asset increases the value of the op�on.

Factor 5 As interest rates rise, the value of op�on contracts also increases.

Real Options

Op�ons associated with capital projects are known as real op�ons. These are called real op�ons, to dis�nguish them from op�ons contracts on stocks and other securi�es.
Real op�ons are important a�ributes of many projects, although they are o�en difficult to iden�fy and value. Here, we look more closely at different types of real op�ons,
and why the valua�on of real op�ons is o�en problema�c.

Many companies have learned that taking into account the op�ons in projects significantly affects their inves�ng decisions. This op�ons approach has become a par�al
subs�tute for long-range planning, which relies on forecasts of future events. By contrast, op�ons thrive on uncertainty. Rather than relying on forecasts to select projects,
companies may seed a number of projects, recognizing that many will never be developed. They expect that those that are developed will be very profitable. By seeding a
number of projects, a company is giving itself the op�on to develop the projects that are most promising as �me goes by and markets develop.

Op�ons as a Strategic Investment. Op�ons are ideal hedges against an uncertain future, such as unforeseen changes in product demand. For example, a car company could
opt to pay an extra $3 million in design and manufacturing costs for a plant that can quickly change produc�on from one model to another. This would allow the
manufacturer to change over produc�on in just a few days, as opposed to the industry standard of several weeks. This changeover op�on represents a hedge against
unforeseen changes in demand for certain car models. It allows the company to reduce the risk associated with an unclear future, but the op�on does come with a price (in
this case, the price is $3 million).

Op�ons to Close Down and Start Up. The op�on to close a project down and then start it back up at a later �me can be valuable. This op�on can be par�cularly profitable
when dealing with products whose market prices are subject to great vola�lity, such as electricity.

The Op�on to Abandon a Project. In NPV analysis, we es�mate the life of the project. However, as men�oned earlier in this chapter, there are �mes when the project should
be abandoned or terminated prior to the end of its expected life. To determine whether the project should be abandoned in any par�cular year, we compare the salvage
value in that year to the discounted value of the project’s remaining cash flows. If the salvage value exceeds the discounted value of the remaining cash flows, then the
project should be immediately terminated. In effect, we are determining whether the project is worth more dead than alive.

To understand the abandonment op�on, consider the prin�ng press project in Table 6.15. The press ini�ally costs $60,000 and will be used to print a weekly newspaper.
Revenues are generated from adver�sing and subscrip�ons. The expected life of the project is six years. The project’s a�er-tax cash flows follow a typical life cycle pa�ern.
They rise as sales build and then fla�en and decline as compe�ng newspapers enter the market or as demand for weekly newspapers wanes. Because the prin�ng press has
many alterna�ve uses, its salvage value ini�ally declines slowly, reflec�ng wear and tear rather than obsolescence. At a discount rate of 12%, the six-year project has a
posi�ve NPV of $14,410, so the project is accepted.

Table 6.15: Cash flows for prin�ng press project

Data Category Year 1 Year 2 Year 3 Year 4 Year 5 Year 6

Opera�ng cash flows $12,000 $16,000 $18,000 $18,000 $14,000 $10,000Processing math: 0%

Salvage value $56,000 $52,000 $48,000 $44,000 $34,000 $27,000

To determine the op�mal termina�on date, we compute the NPV, including salvage value, for each year. For example, if we abandon a�er the first year, we receive the
opera�ng cash flow of $12,000 for Year 1 plus the salvage value of $56,000. Discoun�ng at 12% results in an NPV (abandon a�er year 1) of $714.29

Using this approach, the NPV of abandonment at Years 2 through 5, are

This analysis shows that the highest NPV occurs when the project ends a�er Year 4. Beyond Year 4, the present value of the addi�onal opera�ng cash flows do not
compensate for the loss in the asset’s salvage value. In other words, the cost of con�nuing exceeds the benefits of con�nuing to receive opera�ng cash flows. Being able to
abandon the project early, in Year 4, raises project value by $1,274, which is the value of the project if it is sold in Year 4 minus its value if it is sold in Year 6 (15,684 –
14,410). If the company had to buy the op�on to terminate the project before Year 6, it could pay up to this amount and shareholders would s�ll benefit. Thus, the
abandonment op�on is worth $1,274.

The value of the abandonment op�on increases with the salvage value of the asset. A primary determinant of salvage value is the number of alterna�ve uses for the asset. A
generic asset that can be used in many applica�ons is generally more valuable than a highly specialized asset with few uses. Specialized assets—machines and equipment—
tend to be produc�vely more efficient. Quite o�en a company must consider the tradeoff between a specialized asset that increases opera�ng cash flows by lowering
produc�on costs and a generic asset that increases salvage value.

Adjusting NPV for the Option Effect

Compu�ng a precise value for real op�ons is difficult because the amount and �ming of payoffs is uncertain and, in some cases, not measurable. In some situa�ons there is
no need to make the computa�on. For example, suppose that a project has a posi�ve NPV before considera�on of an abandonment op�on. In this case, the op�on merely
adds value to an already acceptable project. Unless you are faced with pursuing capital ra�oning or choosing between mutually exclusive investments, where the op�on may
change a project’s rela�ve standing among compe�ng projects, there is no reason to calculate the op�on value. Remember that for an independent project the only
requirement for acceptance is that it has a posi�ve NPV.

When a project has a slightly nega�ve NPV before considera�on of poten�ally value-enhancing op�ons, we must es�mate the op�on’s value, using the five factors that affect
op�on value as a guide. A sufficiently valuable op�on could cause us to accept a project that may otherwise be rejected. Any analysis must begin by determining whether or
not the op�on might ever be used. For example, if we know we will con�nue with a project through its en�re economic life, then the abandonment op�on has no value and
no further considera�on is needed. Of course, not all op�ons are imbedded in projects. Some must be purchased. Other op�ons, even though they may be a�ached to
projects, may add cost to the project. In these cases, the decision must be made on whether to buy the op�on, and this requires us to es�mate the op�on’s value.

Ignoring op�ons that are a�ached to investment projects means ignoring some of the projects’ poten�al value, implying that some profitable projects will be rejected.
Valuing real op�ons remains elusive, but the five factors that affect op�on value can serve as a framework for making es�mates. Considering these op�ons, even in this
rough way, helps managers iden�fy profitable investments.

A final word of cau�on: We must be careful when we modify rigorous analyses with educated guesses. It is possible for a manager to use such hasty analysis to make any
project look profitable. If a project is accepted because of the value of its a�ached op�ons, then those op�ons and the source of their value must be carefully considered.
The presence of op�ons, real or imagined, should not be used as a pretext for taking on ill-advised projects.

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Ch. 6 Conclusion

The decision to invest in long-term assets is crucial to the long-run success of a corpora�on. This investment represents the implementa�on of the corporate mission and
goals. If the company does not have a clear sense of where it is going, it may invest its resources in inappropriate product markets. In this chapter, we outlined a process for
transla�ng a corporate strategic plan into iden�fica�on of specific projects. We also suggested a method of classifying projects according to the amount of management
a�en�on required.

We then showed how to dis�ll dependent projects down to an array of independent projects, which can be evaluated using either NPV or IRR. We showed that NPV and IRR
methods of analysis are en�rely consistent with each other for independent projects but may give conflic�ng accept/reject signals when used to choose from among mutually
exclusive projects. If such conflicts arise, we should opt to select projects on the basis of NPV rather than IRR. In the final analysis, NPV gives us a direct measure of the
value added to the company by an investment project.

Finally, we showed that many investment projects also contain call op�ons on future investment opportuni�es and put op�ons on projects that may be terminated. Although
these op�ons may be difficult to value explicitly, they may nonetheless be useful enough to influence the investment decision.

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Ch. 6 Learning Resources

Key Ideas

Fixed assets can be classified as tangible (machinery, real estate) or intangible (copyrights, patents, contracts).
Net present value measures the value added to the firm by an investment. The NPV of an investment is the present value of the future cash flows minus the ini�al
investment.
The IRR criteria compares the expected return for a project to the required return for investors, given the project’s risk. If the expected return exceeds that requirement,
then the project should be pursued.
Companies may choose to undertake three types of projects: replacement, expansion, and diversifica�on.
Mutually exclusive projects are subs�tutes for each other, requiring either/or decisions.
Independent projects all have equal status, meaning that the company may invest in any knowing that each investment decision does not affect the others.
When es�ma�ng cash flows, consider only incremental cash flows by remembering to beware of allocated costs, consider the opportunity costs of currently owned
resources, ignore sunk costs, and consider incidental effects of the project.

Key Equa�ons

Cri�cal Thinking Ques�ons

1. Individuals and families, like corpora�ons, have long-term investments. What are two investments that most families have?
2. Some companies, such as Motorola, spend millions of dollars each year on employee training. The cost of this training is treated as an accoun�ng expense, but it may really

be an investment. Why might training be an investment?
3. Apple is now the highest valued company in the world at over $600 billion. Apple earned this posi�on by producing products with very high profit margins. Think about

Apple’s products and explain what Apple does to maintain such high profit margins (much higher than compe�tors). High profit margins almost always imply products with
large posi�ve NPVs. What is the source of Apple’s huge posi�ve NPVs?

4. Over the past few years, we have seen film cameras and video rental stores disappear, many book stores close, and much discussion about whether print newspapers will
survive this decade. What does this imply about project proposals that assume 10 or 15 years of high cash flows?

5. In July 2011, Nortel Networks, a now closed Canadian telecommunica�ons company, auc�oned off its patents. The auc�on brought in $4.5 billion from bidders that included
Apple, Microso�, and four other companies. Google was among the companies that were outbid. Why would these companies spend so much on patents? See Web
Resources at the end of Chapter 6 for more details about this auc�on.

Key Terms

Click on each key term to see the defini�on.

abandonment
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The op�on to terminate or sell a project before the end of its func�onal life.

a�er-tax cash flows
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The amount of cash flow remaining a�er taxes have been deducted.

allocated costs
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Costs, such as overhead costs, that do not necessarily change as a result of taking on a project.

call op�on
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The right, but not the obliga�on, to buy an asset at a specified price within a specified �me period.

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capital budge�ng
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The process in which a business determines whether projects are worth pursuing.

complementary projects
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Investment projects that are related such that all or none must be taken.

dispersion projects
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Investments that add new geographic regions, including other countries, to a company’s opera�ons.

diversifica�on projects
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Investments that add new products or product lines to a company’s opera�ons.

exercise a call op�on
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The purchase of an asset under the terms of an op�on contract.

exercise price
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Price at which an asset may be bought or sold by the owner of an op�on.

expansion projects
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Investments that expand exis�ng capacity, such as adding new machinery or equipment to increase output.

expira�on date
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The date that an op�on to buy or sell an asset lapses.

fixed assets
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Long-term investments. They may be tangible, such as machinery and equipment, or intangible, such as patents and employee training.

hurdle rate
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A required rate of return, or reference point, against which to compare a project’s internal rate of return.

incidental effects
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Indirect effects of an investment. Costs or revenues not normally associated with the investment.

incremental cash flows
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The change in corporate cash flows a�ributable to a project.

independent projects
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The decision to invest in any project has no impact on the decision to invest in any other project.

internal rate of return (IRR)
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The discount rate that equates the present value of an investment’s future cash flows with the investment’s cost.

mutually exclusive projects
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Investment projects that are related such that only one can be taken.

net present value (NPV)
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The present value of future cash flows minus the ini�al investment. NPV is the present value of all cash flows connected to an investment.
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opportunity costs
(h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro

The amount of the highest valued forgone alterna�ve.

payback period
(h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro

A measure of how many years it takes to recoup the ini�al investment in a project.

put op�on
(h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro

The right, but not the obliga�on, to sell an asset at a specified price within a specified �me period.

real op�ons
(h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro

Op�ons associated with capital projects.

recovery of net working capital
(h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro

The reduc�on in net working capital associated with the termina�on of an investment.

replacement projects
(h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro

Investments that update or upgrade exis�ng capacity; such as replacing worn out or obsolete machinery and equipment.

sunk costs
(h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro

A cost that has already been incurred. The cost is irretrievable. Sunk costs are not relevant in decision making.

Web Resources

A Business Week ar�cle from July 19, 2011 discusses the importance of patents to leading technology companies:
h�p://www.bloomberg.com/news/2011-07-20/patents-are-veryvaluable-tech-giants-discover-nathan-myhrvold.html (h�p://www.bloomberg.com/news/2011-07-20/patents-are-very-
valuable-tech-giants-discover-nathan-myhrvold.html)

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http://www.bloomberg.com/news/2011-07-20/patents-are-very-valuable-tech-giants-discover-nathan-myhrvold.html

Chapter 5

Estimating Cash Flows

Blend Images/Corbis

Learning Objectives

A�er studying this chapter, you should be able to:

Describe the cash cycle of a typical firm.
Explain the significance and use of different financial statements.
Express why accoun�ng profits and cash flows some�mes differ.
Show how accoun�ng profits can be transformed into cash flows.
Explain how to construct pro forma financial statements.
Express how growth impacts a company’s cash flows.
Show how to es�mate expected value of future cash flows.

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Ch. 5 Introduction

Cash—dollars and cents—is the lifeblood of every business. Companies distribute cash to shareholders in the form of dividends and use cash to pay employees and suppliers,
to pay taxes, and to repay loans. For a business to stay healthy, it is cash, not accoun�ng profits, that ma�ers. This may sound like a contradic�on, but many profitable, fast-
growing small companies have gone out of business because they lacked sufficient cash to pay their bills. Regardless of its profitability, a firm without enough cash to pay its
bills risks going bankrupt. Because cash is so important, we must understand how to es�mate cash flow and how cash circulates through a company.

Profitability is not iden�cal to cash flow. One of the key objec�ves of this chapter is explaining why accoun�ng profits and cash flow can differ. This difference hinges on
several of the rules included in the accoun�ng profession’s generally accepted accoun�ng principles (GAAP). We begin by describing the cash cycle of a typical company, then
we relate this cash cycle to basic accoun�ng concepts and the primary financial statements produced by a company.

Once we understand how accoun�ng profits and cash flows differ, we describe two methods for transla�ng accoun�ng profits into cash flows. We use these techniques to
es�mate the future cash flows for a brand-new project or investment. We extend this forecas�ng technique to the crea�on of pro forma (or projected) financial statements.
Once you have mastered these techniques—transla�ng accoun�ng data into cash flows, es�ma�ng cash flows for a new investment, and crea�ng projected financial
statements for a company—you will have gained a sound introduc�on to tools that are used daily by business people in a variety of fields.

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The business of purchasing materials and selling products creates a cycle of intertwined accoun�ng entries
and cash payments and collec�ons.

When customers use credit cards to pay
for products, firms wait for the bank that

5.1 The Cash Cycle of a Typical Firm

For managers of small businesses it is par�cularly important to understand and manage the company’s cash cycle. In fact, the lack of a cash cushion is one of the primary
reasons that small businesses fail. For some of the other reasons, see The New York Times ar�cle “Top 10 Reasons Small Businesses Fail,” in the Web Resources sec�on.

We begin this chapter by describing how cash travels through a typical business enterprise. Understanding the cash cycle will help you see why the profits reported on a
company’s income statement s differ from the actual cash generated by the firm’s ac�vi�es.

Simple Cash Cycle

The opera�ons of a typical firm follow:

1. Goods are produced or purchased for resale.
2. Sales are made.
3. Cash from the sales is collected.

Cash expenditures for materials, wages, adver�sing, and so on occur at stages 1 and 2, but only at stage 3 does cash flow into the firm, providing the cash for another cycle
of produc�on, sales, and collec�ons. Typically, accoun�ng revenues and expenses are recorded at stage 2. If not managed properly, these seemingly slight �ming differences
between the expenditures of cash, and the collec�on of cash, can cause serious problems and even bankruptcy. Figure 5.1 shows a simple cash cycle.

Figure 5.1: Simple cash cycle

In Figure 5.1, the firm buys materials on credit and generates an account payable (A/P). During the manufacturing process, the firm
generates addi�onal costs. Produc�on costs include employee wages and benefits, u�lity expenses, and rent. Another cost of
produc�on is the wear and tear on, or deprecia�on of, equipment, though this doesn’t include any actual cash outlay (we explain the
noncash aspect of deprecia�on later in the chapter).

The firm eventually sells the finished products and recognizes revenues and—it hopes—profits. If a credit sale is made, the firm
receives no cash at the �me of the sale. Instead, the sale creates an account receivable (A/R), and the firm must wait for the
customer to pay the bill before any cash arrives. Profits may be recognized at stage 2, before any cash is actually collected. Thus,
accoun�ng profits (or net income) may not represent cash flow.

Complete Cash Cycle

Figure 5.2 shows a somewhat simplis�c cash cycle. It ignores a number of important factors, such as taxes, dividends, cash infusions
from the capital markets, maintenance of inventory to avoid stock-outs, and the purchase and sale of produc�ve assets. These are
added to the cash cycle diagram presented in Figure 5.2 to give a more complete picture of how cash moves into, out of, and through
the firm. As Figure 5.2 shows, taxes and dividends represent cash flowing out of the firm. The company acquires addi�onal cash from
the capital markets by selling shares of stock, issuing bonds, or borrowing from financial ins�tu�ons. Because the company must pay
its lenders interest and repay the amount borrowed, another cash ou�low is debt service payments (interest and principal). Two
arrows represent the sale and purchase of produc�ve assets such as machinery, vehicles, and factories. To remain compe��ve,

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A more complete depic�on of the cash cycle includes tax payments, disbursements to claimants, and asset
purchases.

issued the card to pay for the
merchandise on behalf of the customer.

Polka Dot/Thinkstock

companies upgrade their manufacturing methods with new equipment, selling the machines that no longer fit their produc�on
processes.

Figure 5.2: Complete Cash Cycle

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The income statement shows revenues and expenses over the course of the year.

5.2 A Review of Financial Statements

You may have already taken one (or more) accoun�ng courses, but accoun�ng is so important to managerial finance that we want to provide a short review. The review is
from a finance perspec�ve, so we will discuss why some accoun�ng items are par�cularly important to financial managers.

Income Statement

The income statement shows a company’s revenues and profits over a set �me period, usually a year or a quarter. It is also called a P&L (profits and loss) statement. An
income statement always begins with the revenues or sales for the period at the top and then shows the costs incurred to make these sales. The costs listed first are the
direct costs associated with the sales, such as materials and manufacturing labor. These items are o�en combined into a single COGS (cost of goods sold) or cost of revenue
expense line. Subtrac�ng these direct expenses from revenues gives us the company’s gross margin. Next on the statement are indirect costs, which include SG&A (sales,
general, and administra�ve) expenses, deprecia�on and amor�za�on expenses, and R&D (research and development) expenses. All of these expenses are considered
opera�ng expenses. Subtrac�ng these expenses produces the opera�ng margin or EBIT (earnings before interest and taxes).

The most common non-opera�ng expenses are interest expense and taxes. Subtrac�ng these items from the opera�ng margin gives us the company’s net income or net
profit. This is the proverbial “bo�om line” that people refer to, as in “What is the bo�om line?” In fact, usually there are a few more lines that show per share informa�on
such as earnings per share and dividends per share. Figure 5.3 shows Nike’s income statement, using the basic structure we have just discussed.

Figure 5.3: Nike income statement, 2011

Data from Nike annual report to the Securi�es and Exchange Commission, 2011:
h�p://www.sec.gov/Archives/edgar/data/320187/000119312511194791/d10k.htm
(h�p://www.sec.gov/Archives/edgar/data/320187/000119312511194791/d10k.htm)

Companies some�mes modify financial statements to be�er reflect how they do business. In Figure 5.4, we see that Nike Inc. has included an expense line �tled “Demand
Crea�on Expense.” The notes to the financial statements explain that this expense is for sponsoring athle�c events and athletes. Apparently Nike sees these types of
expenses as sufficiently different from standard marke�ng ac�vi�es and has separated them out on their statement. No�ce too that several items refer to Notes. The
financial statements reported in a company’s Form 10-K (the annual report filed with the SEC) will have very detailed notes about many accoun�ng items. The standard
statement shown on corporate financial statements is: “The accompanying notes to consolidated financial statements are an integral part of this statement.”

Balance Sheet

The balance sheet shows a company’s financial posi�on at a point in �me, for example as of December 31, 2013, or at the end of a business quarter. A balance sheet based
on informa�on from December 31st will differ from a balance sheet computed on December 1 or January 31. A balance sheet is a financial “snapshot” of a firm’s financial
posi�on at a point in �me. Some balance sheet items are changing constantly. Contrast this to the income statement that covers a period of �me. It is a record of the firm’s
money-making ac�vi�es over a period of �me, such as a year or quarter.

Balance Sheet

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http://www.sec.gov/Archives/edgar/data/320187/000119312511194791/d10k.htm

In any company, capital resources are �ed up in various assets. A balance
sheet is a momentary record of the assets that needs to be accurately
interpreted for types of assets and investments. Why do financial managers
need to understand the func�on of balance sheets?

The balance sheet is a snapshot of a firm’s assets, liabili�es, and equity on a par�cular date.

The balance sheet is also called the statement of financial posi�on. It shows what the company owns and what it owes. It contains three categories of items: assets,
liabili�es, and equity. Assets are tradi�onally shown on the le�-hand side of the balance sheet (or on the top) and liabili�es and equity on the right-hand side (or below the
assets). The liabili�es and equity must equal the assets; the two sides have to balance. Assets are listed according to their liquidity, or how quickly they can be turned into
cash. Cash and marketable securi�es are extremely liquid, whereas inventory is less so since it must be sold and receivables must be collected before they become cash.

Figure 5.4: Nike consolidated balance sheets

The accompanying notes to consolidated financial statements are an integral part of this statement.

Data from: Nike annual report to the Securi�es and Exchange Commission, 2011
h�p://www.sec.gov/Archives/edgar/data/320187/000119312511194791/d10k.htm
(h�p://www.sec.gov/Archives/edgar/data/320187/000119312511194791/d10k.htm)

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http://www.sec.gov/Archives/edgar/data/320187/000119312511194791/d10k.htm

Office equipment like computers are listed
among long-term company assets included
in the PP&E category. Can you think of
other examples that would go into this
category?

Ingram Publishing/Thinkstock

Usually the largest category of long-term assets is plant, property and equipment (PP&E). Plant, property and equipment includes
all the long-lived assets that the company owns, such as factories, machines, cars, trucks, and computers. It is reported as the total
historical cost of purchasing those items. The next line on the balance sheet is accumulated deprecia�on. This is the sum of all
deprecia�on expense associated with these assets since they were purchased. Subtrac�ng accumulated deprecia�on from total
PP&E gives us net PP&E. As items are disposed of, their cost and associated accumulated deprecia�on are subtracted from these
accoun�ng items. Nike’s consolidated balance sheet (Figure 5.4) shows that net PP&E will some�mes be reported instead of
separate lines for the total PP&E and accumulated deprecia�on. Net PP&E shows the book value remaining in a company’s assets;
it is the undepreciated por�on of the assets’ historic cost. Land is an excep�on to this deprecia�on treatment. Land is not
depreciated and will appear on a company’s balance at its historic cost forever.

Liabili�es are listed roughly according to when they must be paid. Current liabili�es, such as accounts payable, wages payable, and
taxes payable, are examples of liabili�es due within a year. Some companies report “current por�on of long-term debt,” which is
the principal repayment on loans or bonds due within one year. Long-term liabili�es include mul�year bank loans, leases, bonds,
and mortgages.

The equity component (o�en called shareholders’ equity) is the difference between assets (what is owned) and liabili�es (what is
owed). The book value of equity is also equal to the historical contribu�ons of shareholders to the firm plus all profits that have
been retained on behalf of shareholders. How we account for these contribu�ons is reviewed in the following paragraphs.

The equity sec�on is o�en separated into three line items:

1. Par value
2. Paid-in capital in excess of par
3. Retained earnings

The first two items are the amounts that shareholders have invested into the company. For common stock the par value or face value is the lowest price that the company
can sell a share of stock. Not all states require par values, so many issues of common stock do not have a par value. When stocks have a par value, it is usually set very low,
for example 1¢ or 10¢ of $1.00. Paid-in capital in excess of par is the amount above the par value that the company collected when it sold stock to investors. If a company
sells shares with a $1.00 par value to investors for $15.00 per share, the paid-in capital in excess of par is $14.00 per share.

The final component of the equity sec�on of the balance sheet is retained earnings. This is the historical accumula�on of profits retained in the firm and invested on behalf
of shareholders. This is not an account which contains actual cash. It is very important that you understand that retained earnings has nothing to do with how much cash the
company has available. All of the money that’s been retained has been used to either purchase assets or to repay liabili�es. The only cash the company has is in its cash
account on the asset side of the balance sheet. Remember, the right-hand side of the balance sheet informs us about the sources of the firm’s financing, whereas the le�-
hand side tells us what the firm has done with those funds.

For most profitable firms, retained earnings is posi�ve. However, it is possible for a company to have nega�ve retained earnings if it has lost money (reported nega�ve net
income) over several years. For corpora�ons, nega�ve retained earnings or nega�ve shareholders’ equity does not mean that shareholders owe the company money. These
investors have limited liability and can only lose the amount they invested. For sole proprietorships this is not the case. The sole proprietor is personally responsible for the
debts of the business, so nega�ve equity is poten�ally serious since it puts the owner’s other assets at risk if legal claims are made against the company.

It is interes�ng to note that some young firms actually have nega�ve equity accounts because they have accumulated nega�ve retained earnings over �me as they develop
their products and markets. The fact that these young and not-yet-profitable corpora�ons have posi�ve share prices for their stock illustrates that market value depends on
the expected future for the company and not on its past record. Here, then, we have an example of the difference between the financial balance sheet introduced in Chapter
1 and highlighted throughout the text, and the accoun�ng balance sheet that we’re reviewing.

The income statement and balance sheet do not stand alone but rather are �ed together by several accounts. For example, deprecia�on expense from the income statement
accumulates in the Accumulated Deprecia�on account on the balance sheet. Also from the income statement, net income, less dividends, accumulates in the Retained
Earnings account on the balance sheet.

Cash Flow

The cash flow statement breaks cash flow into three categories:

1. Cash flow from opera�ng ac�vi�es
2. Cash flow from financing ac�vi�es
3. Cash flow from inves�ng ac�vi�es

The cash flow statement starts with net income for the period. It then adjusts for cash used in or provided by opera�ng ac�vi�es, such as deprecia�on (a noncash charge)
and changes in working capital. Inves�ng ac�vi�es include buying or selling machinery or facili�es, inves�ng in marketable securi�es, and realizing returns from investments
in securi�es. Financing ac�vi�es involve paying dividends to shareholders, repurchasing or issuing stock, and borrowing (or repaying) loans. A company with foreign
opera�ons will usually have an addi�onal item a�er the financing sec�on that shows the effect of exchange rate fluctua�ons on cash flow. When the cash flow impact of all
of these ac�vi�es is summed, it will show the change in cash over the income statement period.

The general rule regarding cash flow is: Increasing an asset account uses cash, and increasing a liability is a source of cash. If a company buys a machine (increasing PP&E), it
spends or uses cash. If the company takes out a loan, it receives cash (the loan is a source of cash but increases a liability account such as Bank Loans). Conversely, repaying
a loan uses cash, and selling an asset is a source of cash.

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The statements of cash flows consolidates the cash ac�vi�es over the year and classifies the ac�vi�es into
opera�ons, financing, and inves�ng categories.

In the Nike statement of cash flows (Figure 5.5), no�ce that the ac�vi�es shown for 2011 reconcile the change in the company’s cash posi�on from $3,079 million at the end
of 2010 to $1,955 million at the end of 2011, exactly as shown on the balance sheet in Figure 5.4.

Figure 5.5: Nike consolidated statements of cash flows

Data from Nike annual report to the Securi�es and Exchange Commission, 2011:
h�p://www.sec.gov/Archives/edgar/data/320187/000119312511194791/d10k.htm
(h�p://www.sec.gov/Archives/edgar/data/320187/000119312511194791/d10k.htm)

As we discuss in detail in Sec�on 5.3, almost every income statement category can have a recorded amount that differs from the actual cash inflows or ou�lows for that
category. You may ask why accountants don’t simply keep track of cash, instead of using the accrual accoun�ng system. In fact, in response to a growing interest in cash flow
informa�on, accoun�ng statements now include a statement of cash flows.

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http://www.sec.gov/Archives/edgar/data/320187/000119312511194791/d10k.htm

Everyone is familiar with cash accoun�ng
as it’s the same system we use to balance
our checkbooks. Most corpora�ons
however use an accrual accoun�ng
system, which is much more complex.

Comstock Images/Ge�y Images

5.3 Why Accounting Profits and Cash Flows Differ

Generally Accepted Accoun�ng Principles (GAAP) prescribe how accountants record business transac�ons and construct financial
statements. These accoun�ng rules were designed to provide an objec�ve portrayal of a company’s business ac�vi�es and how those
ac�vi�es affect the company’s financial posi�on. Three accoun�ng principles are par�cularly important to understanding why
accoun�ng profits o�en differ from cash flows. These principles deal with

1. The recogni�on of revenue
2. How expenses and revenues are matched
3. Rules regarding how the deprecia�on (i.e., wear-and-tear) of long-lived equipment is shown on the income statement

These principles, especially the matching principle, mean that corporate financial accoun�ng is an accrual accoun�ng system, not a
cash accoun�ng system. As we discuss these accoun�ng principles, you will see how accrual accoun�ng differs from cash accoun�ng.
Cash accoun�ng is the system you use in your checkbook. At any moment in �me (except for checks that have been wri�en but
haven’t yet been cashed), the balance shows the cash you have available. As we will see, this is very different from the accoun�ng
used in most businesses.

Revenue Recognition

The rules of revenue recogni�on state that revenues are recorded when a transac�on has occurred. There are several defini�ons of
transac�on. It may be when the �tle or ownership of an item changes from the seller to the buyer. It may be at the �me of delivery
or pickup. In some cases, a transac�on might occur when an order is placed. The actual point at which a sale is considered to have
been completed varies, depending on the nature of the contract or agreement between the buyer and the seller, the rights of the
buyer to renege from the deal, and so on.

One thing to no�ce about the above defini�ons is that none define a transac�on as occurring when money changes hands. There is a
very good reason for this omission. Many sales are made on credit; that is, the buyer delays paying for several weeks or months, or spreads the payments out over �me. If
sales were only recorded as the cash arrived, the sales figure for a par�cular period would reflect the cash collected, not the actual sales ac�vi�es during the period. The
objec�ve of the GAAP principles is to provide an accurate picture of a company’s ac�vi�es, the primary one of which is selling products, not collec�ng cash. Therefore, the
accoun�ng rules are designed to focus more on sales and revenue genera�on than on cash collec�on.

Matching Principle

The rules of accoun�ng require that the expenses recorded on the income statement be those associated with the sales recognized during that period. This is referred to as
the matching principle. Expenses refer to the cost of producing the items sold, not the actual cash outlays for labor, materials, and so on made during the period. For
example, suppose a company manufactures 175 air condi�oners during the month of April but sells 100 of those units in April. On an income statement for the month of
April, the expenses would be the cost of producing the 100 units that the company actually sold, not the 175 that it manufactured. The cost of producing the 75 units that
were manufactured but not sold in April will appear on future income statements when those units are sold. In the mean�me, the cost of producing those 75 units is
recorded as an increase in inventory. If the company paid cash to its employees and suppliers of raw materials for the 175 units produced, the expense shown on the income
statement is less than the actual cash outlays the firm made in April. If the recorded expenses are too low, then net income—revenue minus expenses—overstates how much
cash the firm has generated during the period.

The matching principle may also cause net income to understate cash flow. For example, suppose the firm sold 100 units in April but paid for the raw materials used to
manufacture those units in May. Thus, the cash for the materials was paid in May but was recorded as inventory, and the cost of goods sold expense for the units would
appear in April’s income statement. In this case, the expense shown for raw materials on April’s income statement would be greater than the actual cash outlays made in
April for materials, so April’s income would be lower than its actual cash flow—holding everything else constant.

The matching principle is designed to give users of financial statements an idea of the firm’s ac�vi�es during a specific period of �me. More specifically, the matching
principle is designed to show a firm’s profitability. By focusing on revenues or sales and then matching expenses to that sales level, the income statement presents
informa�on on the profitability of the company’s opera�ons.

Depreciation

When business people use the term deprecia�on (or deple�on or amor�za�on, depending on the asset being considered) they are referring to the alloca�on of the cost of a
long-lived asset to several accoun�ng periods. A machine, vehicle, computer, or building will usually last for more than one year. When a company invests in an asset that will
be used for several years, for accoun�ng purposes it allocates the cost of the asset over several periods as deprecia�on expense. The idea is to match the use (or the
consump�on or wearing out) of the asset to the accoun�ng period in which that use occurs. By repor�ng deprecia�on expense on the income statement as the asset is used,
accountants a�empt to show the total costs of doing business during that par�cular accoun�ng period. It is important to understand that although the cost of the asset is
spread over several years, the purchase was made and paid for when the asset was acquired.

In terms of es�ma�ng cash flows, the alloca�on of deprecia�on means that net income is different than the cash generated during the period. This is most easily shown with
an example. Suppose Acme Metal Fabrica�ng Company purchases a computer-aided lathe in January of 2012 for $100,000. The lathe is expected to last for five years, at
which �me the company plans on trading it in for a newer model. In 2012, Acme writes a check for $100,000. The en�re cash outlay for the lathe is made in 2012. In the
years 2013 through 2016, there are no cash outlays associated with purchasing the lathe, but the company uses the lathe extensively each of those years. To allocate the
cost of the lathe over its es�mated useful life, the company’s accountant adds a deprecia�on expense of $20,000 to the company’s expenses for each of the five years from
2012 through 2016 ($20,000 = $100,000/5).Processing math: 0%

All companies invest in assets that depreciate over �me. Methods of fixed
asset deprecia�on are: straight line, units of produc�on, declining balance,
and sum of year digits. What are the benefits to financial managers in
knowing an asset’s deprecia�on value?

Generally Accepted Accoun�ng Principles (GAAP) are rules that can cause accoun�ng profit to differ from cash
flow.

When the company buys the lathe, it records an increase in fixed assets of $100,000. Each year when it records its deprecia�on expense, it reduces the value of the asset by
the amount of the deprecia�on. In the years 2013 through 2016, the deprecia�on expense has no corresponding cash outlay. Because of this, deprecia�on is o�en called a
noncash expense or noncash charge. The noncash expense lowers net income without affec�ng the firm’s cash posi�on. Of course, in 2012, when the machine was
purchased, there was a cash outlay of $100,000, but an expense for use of the machine of only $20,000 is reported. Therefore, in 2012 the net income overstates the cash
flows of the firm, whereas in the following four years it understates the cash flows.

Fixed Asset Deprecia�on

In many cases, deprecia�on is the major factor that causes accoun�ng profits and cash flows to differ. In Chapter 6, we return to the topic of deprecia�on and describe in
more detail how to compute deprecia�on expense and how firms benefit from deprecia�on tax deduc�ons.

Income Statements and GAAP

Figure 5.6 shows an income statement for Acme Metal Fabrica�ng Company, highligh�ng the company’s opera�ng ac�vi�es during the 2013 fiscal year. Arrows iden�fy the
income statement accounts that can cause net income and cash flow to differ. The sales (or revenue) account may not equal the cash collec�ons for the accoun�ng period
because of revenue recogni�on rules. The matching principle implies that the actual cash flowing into or out of the firm may differ from the amount reported as cost of
goods sold and GA&S expense for that period. GA&S expense reflects costs necessary to operate the business that are not directly �ed to the produc�on of products.
Deprecia�on expense, as we just discussed, is a noncash charge that allocates the cost of long-lived assets to the accoun�ng periods during which the asset is used.
Therefore, the income statement amount does not reflect actual cash outlays during the accoun�ng period.

Figure 5.6: Acme’s income statement and GAAP

Deferred Taxes

Although a detailed discussion is beyond the scope of this text, the amount of taxes reported on company income statements o�en differs from the actual cash payment
made to the Internal Revenue Service and/or state taxing agencies. This results in a deferred taxes liability (it can also be an asset, but this is less common). One of the most
common examples of this occurs when a company uses accelerated deprecia�on for tax purposes but a nonaccelerated method of deprecia�on, such as straight-line, for its

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repor�ng. This creates a �ming difference between when taxes are paid and when they are reported in financial statements. Eventually the difference reverses itself as
accelerated deprecia�on for the asset falls below the amount reported using straight-line.

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A careful examina�on of how the replacement truck will affect earnings and expenses is crucial to maximizing
cash flows. Here, that impact is illustrated in the bo�om sec�on of the income statement.

Purchasing new equipment such as a fuel-efficient truck, despite
increased deprecia�on and lower net income, can actually increase
cash flow. Do you think purchasing the truck would be beneficial?

Associated Press

5.4 Translating Accounting Profits Into Cash Flows

One of the most important tools you will learn in this class is compu�ng the net present value (NPV) of a proposed investment using discount cash flow analysis. As the
name suggests NPV relies on cash flows. We will describe two methods for transforming data from a company’s income statement into an es�mate of cash flow: a quick-and-
dirty method and a more accurate, but somewhat longer, method.

Simple Method

The quick method, which provides a rough es�mate of the cash that the company generated from opera�ons during the accoun�ng period, requires just one step: Add the
deprecia�on expense for the period to net income!

Why does this simple computa�on change net income into cash flow? For many firms, deprecia�on is the main reason that cash flow differs from accoun�ng profit or net
income. If, for items other than deprecia�on, there is only a small difference between recorded expenses and cash outlays, then correc�ng for deprecia�on gets us very close
to cash flow.

This formula (Cash flow from opera�ons = Net income + Deprecia�on) recognizes that deprecia�on is a noncash charge. We know that in the year that a company buys an
asset there can be a large cash outlay to pay for the purchase. No�ce, though, that the formula is for “cash flow from opera�ons.” The formula tries to give investors an idea
of cash flow generated by a company’s day-to-day or month-to-month opera�ng ac�vi�es. As later chapters will show, these are the cash flows that investors are most
interested in. Thus, ignoring the cash flows associated with an infrequent event is o�en not a serious problem if we are most interested in a firm’s opera�ng ac�vi�es.

Now, let’s apply what you just learned about the simple method of es�ma�ng cash flows using an example.

Suppose your company is thinking about replacing a truck with a more efficient model. The new truck will do exactly the same job the older truck did, but it will use less fuel
and have lower maintenance costs. These savings are es�mated to be $3,000 per year, which will increase earnings before taxes by $3,000. The new truck will generate
addi�onal deprecia�on expense of $4,000 per year, which, when combined with the savings, implies that earnings before taxes will actually decrease by $1,000 per year. At a
30% tax rate, net income will decrease by $700! We usually don’t make changes that reduce profits, but we need to look at the cash flow implica�ons of the change. Figure
5.7 shows the bo�om sec�on of an income statement that shows these changes.

Figure 5.7: Change and cash flow

Despite net income falling a bit, cash flow increases by $3,300. This is because much of the decrease in net
income was due to higher deprecia�on (a noncash charge). When we correct for the added deprecia�on
expense, we have an increase in cash flow. In this example, cash flow increased. In the next chapter, we will
learn methods to determine if this increase in cash flow jus�fies spending money on the new truck.

Complete Method

If we need an es�mate of a company’s overall cash flow, then, in addi�on to opera�ng ac�vi�es, we must
consider a firm’s inves�ng ac�vi�es (e.g., its purchase and sale of assets or increases and decreases in asset
accounts) and its financing ac�vi�es (e.g., changes in its borrowing, stock sales, and dividend decisions). This
more precise measure considers changes in all asset and liability accounts. Examples of such balance sheet
effects include increased accounts receivable from more credit sales, changes in accounts payable from the
delayed (or early) payment for supplies, changes in debt and equity accounts caused by new funds the firm
obtained from (or repaid to) banks or investors, and changes to the PP&E account caused by expenditures for
(or proceeds from the sale of) long-lived assets. Table 5.1 summarizes the effect on cash flows due to changes
in assets and liabili�es.

Table 5.1: Effect on cash flows due to changes in assets and liabili�es

Cash increases when . . . Cash decreases when . . .

Assets decrease Liabili�es or equity decrease

Liabili�es or equity increase Assets increase
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Being able to accurately es�mate cash flows into the future is essen�al to the success of a corpora�on.

The concept of a reservoir is helpful in illustra�ng cash flow and
analogizing how companies decide to divert some of their cash flow
money into another account, or “reservoir.”

age fotostock/SuperStock

This is a good �me to take a minute to test your understanding of cash flow and its rela�onship with common business ac�vi�es. Answer the ques�ons in the Applying
Finance: Cash Flow feature to assess your understanding.

Applying Finance: Cash Flow

Instruc�ons: Does the described ac�on increase (INC) or decrease (DEC) cash flow?

1. Selling a machine?
2. Repaying a bank loan?
3. Purchasing a fleet of delivery vehicles?
4. Making more sales on credit?
5. Accelera�ng the payments to suppliers to take advantage of a cash discount?
6. Building up inventory in prepara�on for high holiday sales?
7. Increasing the money in the Cash & Marketable Securi�es account?

See Appendix B (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/appb#appB) for the answers.

The item in the Applying Finance: Cash Flow feature that might have confused you is 7—”Increasing the money
in the Cash & Marketable Securi�es account?” We are measuring cash flow, the money moving between
accounts within the company, or the money available to invest or pay bills. If we decide to increase our cash
reserves we are taking money from that available pool and se�ng it aside. The flow of usable cash has go�en
smaller. Consider a river running through a town. The water in the river is our cash flow. If the town decides to
divert some of that water into a reservoir to use during a dry period, the flow in the river has been reduced.
The reservoir is analogous to the Cash & Marketable Security account. Having more money in that account is a
valuable resource if the company faces a downturn in sales or wants to pursue a great growth opportunity, but
building up that reserve (i.e., filling up the reservoir) reduces cash flow (water flowing in the river).

Now, let’s look at an example where we need to consider changes in balance sheet items as well as
deprecia�on to get a good es�mate of cash flow.

Suppose a company is considering offering a new product. The product will increase earnings before
deprecia�on and taxes, as shown in Figure 5.8. The addi�onal sales must be supported by increased working
capital investments. The sales will be mostly on credit so accounts receivable will increase (an increase in an
asset account uses cash flow), more inventory will be required to avoid stock-outs (an increase in an asset
account requires cash ou�low), but there will also be some spontaneous financing from an increase in
accounts payable (an increase in a liability account generates cash inflow). The company es�mates that the new product will require a working capital investment equal to
25% of sales.

Figure 5.8: Cash flow es�ma�on

Considering the required investment in working capital changes the annual cash flow significantly. No�ce that in Year 2 the working capital requirement is $17,500. Since
$12,500 was invested in Year 1, an addi�onal investment of only $5,000 is required in Year 2. Also note that in Year 4, as sales decline, working capital is released enhancing
cash flow. The release of working capital occurs because as sales fall the company provides less credit to customers and needs less inventory to sa�sfy orders.

Had we ignored the working capital investment in this example, our es�mates of cash flow would have been incorrect and could have led to a poor decision about whether
or not to introduce this product.

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https://content.ashford.edu/books/AUBUS650.13.1/sections/appb#appB

We will use ACME Inc.’s historical income statements to build a pro forma income statement.

5.5 Pro Forma Financial Statements

Pro forma (or projected) financial statements are powerful tools for the financial manager or analyst. They help the financial manager forecast how changes in policies will
affect the company’s financial situa�on. For example, how will changing a company’s credit policy change the size of its short-term bank loan? One of our students who
became an investment banker doing leveraged buyouts of companies says that he used pro forma statements more than any other financial tool. In this sec�on, we first
show the mechanics of crea�ng a pro forma income statement and balance sheet, then we discuss where an analyst would get the informa�on required for these
statements.

The Pro Forma Income Statement

A fairly standard method for construc�ng pro forma income statements is to use historical percent-of-sales for many categories, supplemen�ng with addi�onal informa�on
when it is available. The approach is as follows:

Step 1: Obtain sales es�mates or es�mated sales growth from the previous year.

Step 2: Compute cost of goods sold, as a percent of sales based on historical data. If informa�on is available about possible changes in the cost structure, this can be used to
modify the es�mate.

Step 3: Compute gross margin (Sales – Cost of goods sold).

Step 4: Determine general, administra�ve, and sales expense, deprecia�on expense, and other expenses, based on historical pa�erns from previous years, or cost es�mates
from other departments.

Step 5: Compute taxable income by subtrac�ng the expenses in Step 4 from the gross margin.

Step 6: Compute taxes using the company-wide rate or rates from tax tables; then subtract taxes from taxable income to arrive at net income.

Now we will demonstrate how to build a pro forma income statement using the steps listed above. We will use ACME Inc.’s income statements for 2011 and 2012 to
construct a pro forma income statement for 2013 based on some assump�ons about how the business will perform during 2013. Below we list the assump�ons for 2013,
while the historical income statements for the company appear in Figure 5.9.

Assump�ons for 2013:

Sales will increase by 10% in 2013 from 2012 levels.
COGS and SG&A will be the average percent of sales they were for the last two years.
Deprecia�on expense will increase to $1,800.
Interest expense will be $840.
The tax rate is 25%.
Dividend payout will remain at $650.

Figure 5.9: ACME Inc. historical income statements

Using this data, we can start solving for the informa�on needed to create our pro forma income statement. According to our assump�ons, sales will increase by 10% in 2013,
so 1.10 × $48,000 = $52,800. In 2011 and 2012, COGS were 72% of sales. We assume that COGS remains 72% of sales in 2103. SG&A expense was 13% of sales in both 2011
and 2012, so we will use that percent of sales in 2013. With this informa�on, we can begin building the pro forma income statement, as seen in Figure 5.10.

Figure 5.10: ACME Inc. pro forma income statement

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Using our assump�ons for 2013, and the historical income statements, we were able to construct ACME Inc.’s
pro forma income statement.

Once a pro forma balance sheet is created, it is important for
company managers to work together to discuss the implica�ons of
the balance sheet before making major financial decisions.

In Pictures/Corbis

Star�ng with sales, we enter the informa�on we have and then subtract items to get gross margin, EBIT, and taxable income. We compute taxes at 40% and subtract them
from taxable income to get net income. We subtract dividends from net income to determine how much money will be reinvested in the firm by adding it to retained
earnings on the balance sheet.

The Pro Forma Balance Sheet

Pro forma or projected balance sheets are o�en necessary when analyzing the effect of corporate decisions on
the company’s financial condi�on. One of the most common uses for pro forma balance sheets is es�ma�ng
future financial need, so a company can make arrangements for loans or lines of credit. Some loans require
that the borrower maintain financial ra�os at or above a certain level. Therefore, before managers of a
company subject to such a loan arrangement ini�ate changes that could affect the company’s balance sheet,
they would want to construct pro forma balance sheets to ensure that the loan restric�ons are sa�sfied.

Construc�ng a simple pro forma balance sheet usually requires four steps. More complex balance sheets
require more steps. The construc�on of the balance sheet depends on having already completed the
appropriate pro forma income statement, so the pa�ern given here assumes the income statement is available.

Step 1: Fill in all of the values that don’t change, that are known, or that change in a definite manner. These
include items such as long-term debt and the common stock accounts.

Step 2: Fill in all values from income statement. These are deprecia�on and retained earnings.

Step 3: Fill in all values that are projected according to company policy or that represent target policy values.
These include inventory, accounts receivable, accounts payable, and plant, property, and equipment. Some of

these will change as a percent of sales. O�en the Cash account is set at some minimum based on sales.

Step 4: Add up the asset side of the balance sheet and transfer that total to the liabili�es and equity side. Balance the assets and liabili�es by adjus�ng a plug figure, usually
bank loans or notes payable on the liabili�es side of the balance sheet. If the bank loan is nega�ve, make it zero, add up the liabili�es, move that total to total assets, and
adjust the asset side with the Cash account taking up whatever slack is necessary to balance things.

We will demonstrate with an example that builds on the pro forma income statement we just completed for ACME Inc. The actual balance sheet for 2012 is shown in Figure
5.11. We will construct the pro forma balance sheet for 2013 using the following assump�ons:

The minimum cash balance is 3% of sales.
Working capital accounts (A/R, A/P, and Inventory) will be the same percent of Sales in 2013 as they were in 2012.
$4,000 of new PP&E will be purchased in 2013.
Other current liabili�es will remain at 2% of sales in 2013.
There will be no changes in the Common Stock or Long-term Debt accounts.
The plug figure is bank loan.

Figure 5.11: ACME Inc. balance sheet

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The accoun�ng balance sheet is one of the most important sources of tracking business progress.

The pro forma accoun�ng balance sheet will allow ACME Inc.’s management to project business ac�vity into
the future.

Now we can complete our pro forma balance sheet. We add the items that we know for 2013, then fill in the asset side of the balance sheet. We work up from the bo�om
of the liabili�es side of the balance sheet by first transferring total assets to total liabili�es and equity. We work our way up the liabili�es side un�l there is one item le�. In
our example, the last cell will be the Bank Loan account. The Bank Loan account must put the balance sheet in balance so the Bank Loan amount is our plug figure; it is the
number that makes things balance. Figure 5.12 shows the completed pro forma balance sheet for ACME Inc.

Figure 5.12: ACME Inc. pro forma balance sheet

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A company’s financial situa�on some�mes becomes evident over a period of �me. Some�mes, a company
cannot financially sustain rapid growth.

As small businesses grow, they must watch their cash inflow to
make sure they do not grow so fast that they have no money to
pay their expenses.

Erich Schlegel/Corbis

5.6 How Growth Affects Cash Flow

Many profitable small businesses fail because they grow too fast for the amount of cash they have. One of the authors watched a very profitable small company grow and
fail because of the lack of cash. Government agencies hired the company to duplicate and store records such as land �tles, surveying plats, building permits, and other
documents that governments generate that might be called on in the future if a dispute or ques�on arises. The owner had enough money to purchase the equipment and
have a small cash reserve. Business picked up quickly because local governments had a mandate to store these items, but had neither a system nor the labor to do so. The
business was very profitable in an accoun�ng sense, but it failed. The problem was that the government agencies were slow to pay their bills. The owner had to pay his
expenses right away but had to wait 90 to 120 days to receive payments from the government agencies. Every �me around the cash cycle, the business accrued a larger bill
for expenses than it did cash from customers. The financing gap—the gap between having to disburse cash to suppliers and receiving cash from customers—con�nued to
grow with each cash cycle. Figure 5.13 shows a stylized version of the company’s financial situa�on.

Figure 5.13: The company’s financial situa�on

You can see from the figure that as the company con�nued to grow the cash outlays also grew. The inflows
lagged the outlays by three months, so as long as the company kept growing, the net cash flow (inflows-
ou�lows) grew. If the cash reserve was only $100,000 or $150,000, you can see that the company could only
remain in business for four or five months. Unless the company slowed its growth, the inflows could not catch
up with the ou�lows. This is known as nega�ve cash flow. Later in the text, we will discuss how to es�mate a
sustainable growth rate.

This par�cular story had a sad end. The owner of the business couldn’t get a very large bank loan and decided
to make up the funds by not paying the taxes that he had withheld from employees paychecks (This is illegal!).
Eventually the tax authori�es caught him, and the business was shut down.

The moral of the story is that it is be�er to turn away some business than fail. And, always pay your taxes.

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Securi�es analysts play an important role
in compu�ng expected cash flows and
advising investors on investment
opportuni�es.

Photographer’s Choice/Ge�y Images

5.7 Computing Expected Cash Flows

When we discuss cash flows from investments, we are talking about future or expected cash flows. Inves�ng today generates payoffs in the future. Therefore, when
evalua�ng investment opportuni�es, we must try to es�mate each investment’s expected cash flows. In finance, we say that investors form expecta�ons about these future
payoffs. The best es�mate of an investment’s future payoff is called the expected value of future cash flows. The expected value is a weighted average, with the weights
being probabili�es. Suppose a security analyst (a person who analyzes stocks and then makes recommenda�ons to clients on whether to buy, hold, or sell the stocks) believes
that Chevron Corpora�on (Ticker: CVX), a leading oil producer, will pay a dividend next quarter of between $0.70 and $1.00. More precisely, the analyst thinks that there is a
10% chance the dividend will be $0.70, a 30% chance it will be $0.80, and a 40% it will be $0.90, and a 20% it will be $1.00. The expected value of Chevron’s next dividend
is computed by mul�plying each of the possible outcomes ($0.70, $0.80, $0.90, and $1.00) �mes its respec�ve probability and then adding up these products. Arithme�cally,
the expected dividend is

Expected dividend = 10% × $0.70 + 30% × $0.80 + 40% × $0.90 + 20% × $1.00 = $0.07 + $0.24 + $0.36 + $0.20 = $0.87

The expected value is slightly more than the middle of the value ($0.85) because the analyst assigns a slightly higher probability to
the $0.90 outcome. No�ce that the analyst predicts that the dividend will be either $0.70, $0.80, $0.90, or $1.00. Nowhere does
the analyst predict a dividend of $0.87. The actual outcome will not be the expected value of $0.87. Although we compute an
expected value for a given point in �me (next quarter’s dividend, next year’s sales, etc.), expected values are long-run averages. If
this set of possible outcomes and probabili�es occurred many �mes, the average dividend from those many occurrences would be
the expected value, $0.87.

As this example shows, the expected value is a probability weighted average. Each possible outcome is weighted by the likelihood
that it will occur; then these weighted outcomes are summed. Mathema�cally, the expected value is expressed as follows:

Where CFi represents one of the possible cash flow levels (e.g., in the Chevron example, CF1 = $0.70) and pi represents the probability of that cash flow level actually

occurring (the probability associated with the $0.70 outcome in the Chevron example is 10%). The probabili�es, π1 through πn must sum to 1.0 or 100%. The sigma, ∑, is a

summa�on sign, which means we add up all of the separate elements created as our counter i goes from 1 to n. The formula for expected value allows for an unlimited
number of possible outcomes because n, the last outcome, can be as large as we want it to be.

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Ch. 5 Conclusion

This chapter discussed cash flow. Cash is the lifeblood of a business enterprise. Despite having accoun�ng profits, a business without cash is doomed. Without cash the
company cannot pay its employees, its suppliers, its tax bill, or its bankers. Our discussion of cash flow focused on understanding how cash flows into, out of, and through
the company. The cash cycle is a valuable tool for thinking about the day-to-day opera�ons of any business. A�er our accoun�ng review, we explained why accoun�ng profits
differ from cash flow. The majority of the chapter discussed how to es�mate cash flows from income statement and balance sheet informa�on and how to es�mate the cash
flows for a new investment project using pro forma (or projected) income statements. If you have a good understanding of cash flow—its importance and how to es�mate it
—and have mastered some of the analy�c tools introduced in this chapter, you have taken a significant first step in learning how to manage a financially healthy business.

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Ch. 5 Learning Resources

Key Ideas

The simple cash cycle is made up of three steps:
1. The purchase of materials and manufacture of goods;
2. The sale of goods;
3. The collec�on of accounts receivable, payment of accounts payable, and purchase of more material.

The complete cash cycle expands on the simple cash cycle. It includes addi�onal steps, such as payment of taxes, disbursements to claimants, and asset purchases.
The income statement is important because it shows revenues and expenses over the course of the year.
The accoun�ng balance sheet is one of the most important sources of tracking business progress.
The statement of cash flows consolidates the cash ac�vi�es over the year and classifies the ac�vi�es into opera�ons, financing, and inves�ng categories.
The simple method for transla�ng accoun�ng profits into cash flows is achieved by adding the deprecia�on expense for an accoun�ng period to net income.
The complete method for transla�ng accoun�ng profits into cash flows requires the considera�on of a firm’s opera�ng, inves�ng, and financing ac�vi�es.
Pro forma financial statements help the financial manager forecast how changes in policies will affect the company’s financial situa�on.
The effects of rapid company growth are not always sustainable. Ou�lows cannot exceed inflows, otherwise the company will fail.
The expected value of future cash flows is the best es�mate of an investment’s future payoff.

Key Equa�ons

Cri�cal Thinking Ques�ons

1. If a project analysis shows accoun�ng losses (nega�ve net income), does that ensure that the project should not be pursued? Imagine a project with large capital investments
and correspondingly large deprecia�on.

2. Suppose two new companies are iden�cal in all ways except that one uses an accelerated deprecia�on method and the other uses the straight-line method. Ini�ally, which
company will have the higher profits? Which will have the higher cash flow? Explain your answers using a simple income statement.

3. In a company there are two divisions compe�ng for investment funds. Manager A proposes a project that uses some idle capacity on exis�ng machines. Manager B, her
compe�tor, says that Manager A should include deprecia�on expense for that idle machinery in the cash flow es�mates of Manager A’s proposal. Will including extra
deprecia�on from exis�ng machinery make the project look worse as Manager B hopes?

4. Some financial analysts use EBITDA (Earnings before Interest, Taxes, Deprecia�on and Amor�za�on) as a proxy for cash flow. Would this be a be�er metric of cash flow
available to service debt or available to equityholders? It might be helpful to use an income statement to explain your answer.

5. We say, “An increase in an asset account is a use of cash.” But the Cash account is an asset account, so how can an increase in the Cash account be a use of cash?
6. Sec�on 5.1 introduced the cash cycle: purchasing materials to produce inventory, making a sale, and finally collec�ng the cash from the sale. One way to think about the cash

cycle is in terms of days. Inventory days tells us how long it takes from buying materials (or items for resale) to selling an item. Receivable days tells us how long it takes to
collect cash a�er a sale is made, and Payables days tells us how long we have to pay our suppliers for materials or merchandise. The cash cycle can be seen as Inventory days
+ Receivable Days – Payables days. If a company has a nega�ve cash cycle that means that it collects cash from a sale before it must pay its suppliers. Is a nega�ve cash cycle
good or bad for a company? Is it the same thing as nega�ve cash flow?

Key Terms

Click on each key term to see the defini�on.

balance sheet
(h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro

Snapshot of a company’s financial posi�on at a moment in �me. The le�-hand side lists assets and the right-hand side lists liabili�es and owners’ equity.

cash cycle
(h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro

The sequence of ac�vi�es associated with cash moving through the company.

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cash flow
(h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro

The amount of money that passes through a corpora�on. Residual cash flow, for example, refers to the amount of money that stockholders have a claim on a�er all other
claims have been paid.

deprecia�on
(h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro

An accoun�ng expense designed to reflect the wear and tear or use of a long-lived asset.

expected cash flow
(h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro

The future cash flow from an investment computed by assigning probabili�es to various outcomes.

expected value of future cash flows
(h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro

The probability weighted value of an investment, computed by assigning a probability of occurrence to the various possible future values.

financing gap
(h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro

The days or dollars that a company must finance with reserves before cash from sales flow into the company.

generally accepted accoun�ng principles (GAAP)
(h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro

The accoun�ng rules that define how companies construct their financial reports. Designed to provide as accurate as possible a picture of a company’s opera�onal ac�vi�es
and financial posi�on.

gross margin
(h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro

Represents the amount of revenue that is le� a�er costs to cover opera�ng expenses.

income statement
(h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro

A record for a period of a company’s opera�onal ac�vi�es. Some�mes referred to as a P/L or profit/loss statement because the bo�om line of the report provides profit or
loss income informa�on.

matching principle
(h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro

The accoun�ng rule that matches expenses for a period to the number of units sold during the period. Designed to help users of financial statements determine whether a
firm can earn profits.

nega�ve cash flow
(h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro

Cash ou�lows exceed cash inflows. Even profitable companies may experience nega�ve cash flow on occasion.

opera�ng expenses
(h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro

Expenses that arise during the ordinary course of running a business. These include salaries paid to employees, research and development costs, legal fees, accountant fees,
bank charges, office supplies, electricity bills, business licenses, and more.

opera�ng margin
(h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro

The total pre-tax profit a business generated from its opera�ons.

pro forma (or projected) financial statements
(h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro

Financial statements for future periods constructed based on historic financial ra�os and assump�ons about how the firm will perform in the future. They are useful tools for
analyzing many types of corporate decisions.

revenue recogni�on
(h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro

Accoun�ng rules that explain when a company may recognize a transac�on as a sale. Companies with aggressive accoun�ng strategies recognize revenue as early as possible,
while more conserva�ve companies delay un�l they are certain of the amount to be collected.

statement of cash flows
(h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro

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An accoun�ng statement that shows cash from opera�ng, inves�ng, and financing ac�vi�es.

Web Resources

To read The New York Times ar�cle “Top 10 Reasons Small Businesses Fail,” see:
h�p://boss.blogs.ny�mes.com/2011/01/05/top-10-reasons-small-businesses-fail/ (h�p://boss.blogs.ny�mes.com/2011/01/05/top-10-reasons-small-businesses-fail/)

To see Nike’s financial report and notes, visit:
h�p://investors.nikeinc.com/Theme/Nike/files/doc_financials/AnnualReports/2011/docs/Nike_2011_10-K
(h�p://investors.nikeinc.com/Theme/Nike/files/doc_financials/AnnualReports/2011/docs/Nike_2011_10-K )

Learn more about Ernst & Young’s U.S. GAAP vs. IFRS: The Basics here:
h�p://www.oglethorpe.edu/faculty/~c_benton/intermediate/documents/ifrsvsusgaapbasicsmarch2010copy
(h�p://www.oglethorpe.edu/faculty/~c_benton/intermediate/documents/ifrsvsusgaapbasicsmarch2010copy )

For more informa�on on deferred taxes, see:
h�p://www.centrec.com/resources/ar�cles/finanalysisfarmranches/deferredtaxes (h�p://www.centrec.com/resources/ar�cles/finanalysisfarmranches/deferredtaxes )

EBITDA is some�mes used as a measure of cash flow (see Cri�cal Thinking Ques�on 4). Here is an interes�ng applica�on of EBITDA to company valua�on:
h�p://www.inc.com/guides/2010/10/how-to-understand-earnings-or-ebitda.html (h�p://www.inc.com/guides/2010/10/how-to-understand-earnings-or-ebitda.html)

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http://investors.nikeinc.com/Theme/Nike/files/doc_financials/AnnualReports/2011/docs/Nike_2011_10-K

http://www.oglethorpe.edu/faculty/~c_benton/intermediate/documents/ifrsvsusgaapbasicsmarch2010copy

http://www.centrec.com/resources/articles/finanalysisfarmranches/deferredtaxes

http://www.inc.com/guides/2010/10/how-to-understand-earnings-or-ebitda.html

Required Resources

Text

Byrd, J., Hickman, K., & McPherson, M. (2013).

 

Managerial Finance

 [Electronic version]. Retrieved from https://content.ashford.edu/

· Chapter 5: Estimating Cash Flows

· Chapter 6: Capital Budgeting – Investing to Create Value

Article

Biery, M.E. (2013, April 12). 

Businesses seeking working capital—survey (Links to an external site.)

. Forbes. Retrieved from http://www.forbes.com/sites/sageworks/2013/04/12/businesses-seeking-working-capital-survey/
Accessibility Statement does not exist.

Privacy Policy (Links to an external site.)

Multimedia

Wiley CMAexcel (2016, February 10). 

Free CMA exam lesson: Capital budgeting process (Links to an external site.)

. Retrieved from https://www.youtube.com/watch?v=h_ouhhkEaKg

Accessibility Statement (Links to an external site.)

Privacy Policy (Links to an external site.)

INTELECOM. (Producer). Management of Working Capital Case Study: “George’s Trains”. [Video File]. Retrieved from the Intelecom Video Library.
Accessibility Statement does not exist.
Privacy Policy (Links to an external site.)

 

Week 3 Journal Capital Budgeting

Review the following video: Wiley CMA excel (2016, February 10). 

Free CMA exam lesson: Capital budgeting process (Links to an external site.). Retrieved from https://www.youtube.com/watch?v=h_ouhhkEaKg
Accessibility Statement (Links to an external site.)
Privacy Policy (Links to an external site.)

Critically reflect on the importance of capital budgeting. Why is this such a heated subject in many boardrooms? How does capital budgeting promote the financial health of an organization? How will you use the financial techniques you have learned this week to promote the financial health of your organization?

Carefully review the 

Grading Rubric (Links to an external site.)

 for the criteria that will be used to evaluate your journal entry.

Week 3 – Assignment

Management of Working Capital Case Study: “George’s Trains”

View the following video: INTELECOM. (Producer). Management of Working Capital Case Study: “George’s Trains”. [Video File]. Retrieved from the Intelecom Video Library.
Accessibility Statement does not exist.
Privacy Policy (Links to an external site.)

 

It appears that George is running a profitable business. George is aware you are in an MBA Managerial Finance class and comes to you for advice on his working capital practices. More specifically George asks you to do the following:

· Describe his working capital practices, including his methods of capital budgeting analysis techniques.

· Analyze the potential pitfalls in his capital budgeting practices that George should be aware of.

· Develop a simple statement of cash flows for George’s Trains using any information gleaned from the video. What areas of improvement do you recommend? Provide at least three references from the Ashford University Library or other scholarly sources to support your recommendations.

In a three- to five-page paper (excluding the title and reference pages), respond to George’s request for advice in detail. The paper should be properly formatted in alignment with APA 6th edition formatting.

Carefully review the Grading Rubric (Links to an external site.) for the criteria that will be used to evaluate your assignment.

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