This is a comprehensive example, that shows you all the steps and issued involved. For each capital budgeting problem, the goal is to get to the Cash Flow from Assets, or, in the case of project evaluation, the Cash Flows from the Project. This is done by looking at all relevant and incremental cash flows, on an after-tax basis, that are directly associated with the project. From the first weeks of class we learned that:

    Cash Flow from Assets = Operating Cash Flows - Additions to Net Working Capital - Net Capital Spending

    and:

    Operating Cash Flow = EBIT + Depreciation - Taxes

The first goal is then to set up the pro forma income statement for each year, which allows you to find the numbers relevant for finding the Operating Cash Flow:

    Income Statement
    Revenues
    Expenses (-)
    Depreciation (-)
    EBIT
    Taxes (-)
    Net Income*

    * Interest payments are irrelevant cash flows in capital budgeting problems.
 

    $100,000 consultancy fee = sunk cost = irrelevant cash flow
        $75,000 marketing research costs = sunk cost = irrelevant cash flow
        $50,000 cost of building in 1985 = sunk cost = irrelevant cash flow
        $60,000 market value of building = opportunity cost = relevant cash flow
        increase in coconut shakes = side effect = relevant cash flow
        method of financing (bonds) = irrelevant

        Remember to make sure that all included cash flows should be reported on an incremental and after-tax basis!

Pro Forma Income Statements
 

^(a) The alternative to using the building for the project is to sell if for the market price of $60,000. Because the book value of the building is $0, the profit you make from selling it is $60,000, which is taxable. So, the after-tax cash flow is (1 - 0.34) * $60,000 =  $39,600
^(b) The incremental effect on the sales of coconut shakes is 10% of $1 million = $100,000.
^(c) Straight-line depreciation is $900,000 / 3 years = $300,000 per year. Using the half-year convention, only $150,000 is used for year 1, and the final $150,000 will occur in year 4. However, in year 3 we can sell the machine, so we won't take the depreciation in year 4.

Additions to Net Working Capital
 
 

Year	Total Net Working Capital	Incremental Cash Flow
0	$25,000	$25,000
1	192,000 (d)	167,000
2	288,000	96,000
3	-	(288,000)(e)

^(d) 12% of $1,600,000 (revenues)
^(e) recovery of investments in NWC

Cash Flows
 
 

Year	Operating Cash Flow	- additions to NWC	- Net Capital Spending	Cash Flow from Project
0	($39,600)	$25,000	$900,000	($964,600)
1	433,800	167,000	-	266,800
2	484,800	96,000	-	388,800
3	484,800	(288,000)	(150,000)(f)	922,800

^(f) Value from selling the machine in year 3. Note that the book value is still $150,000 in year 3 so there is no taxable profit in this case from selling it for $150,000. You only pay taxes on the difference between the market price and the book value.

Net Present Value

r = 21%

NPV = (964,600) + [266,800 / 1.21] + [388,800 / (1.21)²] + [922,800 / (1.21)³] = $42,348.04 > 0 => Accept the Project!