COMM 309 | Chapter 14: Cash Flow Estimation and Capital Budgeting Decisions | Page 1
COMM 309 — Business Finance
CHAPTER 14: Cash Flow Estimation and Capital Budgeting
Decisions
Comprehensive Exam Preparation Notes
14.1 GENERAL GUIDELINES FOR CAPITAL EXPENDITURE ANALYSIS
Chapter 13 introduced the capital budgeting evaluation criteria (payback period, NPV, IRR, PI) and
assumed that cash flows were given. Chapter 14 focuses on how to actually estimate those cash flows
— the most critical and often most difficult part of capital budgeting in practice. All estimates draw on
the firm's financial statements (Chapters 3 and 4) and Canada's Capital Cost Allowance (CCA) system.
The following 12 guidelines govern how cash flows should be estimated for capital budgeting
decisions:
1. Estimate all cash flows on an AFTER-TAX basis. Capital budgeting uses the firm's after-tax
marginal cost of capital (WACC) as the discount rate. To ensure consistency (comparing like with
like), all cash flows must also be stated on an after-tax basis.
2. Use MARGINAL (INCREMENTAL) cash flows — only the changes in cash flows that result
directly from the investment decision. This includes the effect on existing operations. If a new
product cannibalizes existing sales (e.g., a new product that generates $100K/yr but reduces
existing product sales by $40K/yr), only the net incremental $60K/yr should be used.
3. Do NOT include interest or dividend payments in the cash flows. Financing costs (interest,
dividends) are already captured in the discount rate (WACC). Including them in cash flows as
well would double-count them. Finance is always about separating the investment decision from
the financing decision.
4. Adjust for changes in net working capital (NWC). Projects often require additional investment in
current assets (inventory, accounts receivable) that ties up cash. These represent cash outflows
at the start and cash inflows at the end. NWC changes net to zero over the project life, but their
present values do NOT net to zero.
5. Treat SUNK COSTS as irrelevant. Costs already spent cannot be recovered regardless of the
decision going forward. Never 'throw good money after bad' — only future cash flows matter.
6. Include OPPORTUNITY COSTS. The value of resources already owned that will be used in the
project must be included at their current market (opportunity) value. Example: Land purchased
for $150K is now worth $200K. If used for a new project, the $200K current market value is an
opportunity cost — not the $150K original cost (which is sunk). The opportunity cost IS the
relevant cost.
7. Determine the appropriate TIME HORIZON. Projects should run as long as they are
economically viable — abandonment decisions must be considered. Projects are terminated
when it is economical to do so, not when engineers say the equipment stops functioning.
8. Ignore intangible benefits that cannot be estimated. Intangible benefits are sometimes used to
justify poor projects. If spinoffs can be quantified, incorporate them; otherwise, ignore them.
9. Ignore EXTERNALITIES. Externalities are consequences that benefit or harm third parties
unrelated to the firm (e.g., pollution, regional employment effects). These are not the firm's
responsibility for financial analysis; they are the government's domain. However, they may
significantly affect the final investment decision.
, COMM 309 | Chapter 14: Cash Flow Estimation and Capital Budgeting Decisions | Page 2
10.Consider PROJECT INTERDEPENDENCIES. Projects may be contingent (require each other) or
mutually exclusive. Undertaking a project now may create future opportunities (real options) even
if the short-term NPV is negative.
11.Treat INFLATION CONSISTENTLY — the fundamental principle is to compare like with like.
Either: (a) use NOMINAL (actual) cash flows with NOMINAL discount rates; or (b) use REAL
(inflation-adjusted) cash flows with REAL discount rates. Never mix the two. In practice, the
nominal approach is preferred because CCA deductions are fixed in nominal dollars.
12.Undertake all SOCIALLY REQUIRED investments by law, even if they have negative NPVs.
Regulatory compliance is mandatory regardless of financial returns.
📌 The Three Most Commonly Confused Guidelines — Exam Focus
SUNK COSTS vs. OPPORTUNITY COSTS:
Sunk cost: Already spent, cannot be recovered → IGNORE. (e.g., $150K paid for land 5 years ago)
Opportunity cost: What you give up by using a resource elsewhere → INCLUDE at current market
value. (e.g., $200K current market value of that same land)
INTEREST PAYMENTS: NEVER include in cash flows. They are already in the discount rate (WACC).
Including them would double-count financing costs.
CANNIBALIZATION: When a new product reduces existing product sales, the lost cash flows from the
existing product are NEGATIVE incremental cash flows that MUST be deducted. Only the net
incremental cash flows should be evaluated.
WORKING CAPITAL: NWC changes sum to zero over the project life (invested at start, recovered at
end), but their PRESENT VALUES do NOT sum to zero because of the time value of money. The
recovery is worth less than the initial outlay.
14.2 ESTIMATING AND DISCOUNTING CASH FLOWS
Capital budgeting cash flows are organized into three categories, each estimated separately and then
combined to compute the project's NPV. The three categories are: (1) the initial after-tax cash flow
(CF₀), (2) the expected annual after-tax cash flows (CFt), and (3) the ending (or terminal) after-tax cash
flow (ECFn).
The Initial After-Tax Cash Flow (CF₀)
The initial after-tax cash flow (CF₀) is the total cash outlay required to get the project up and running at
time zero. It is NOT the same as the capital cost (C₀) of the investment — CF₀ is broader and includes
all cash items at initiation, even those that cannot be depreciated for tax purposes.
Eq. 14-1 | Initial After-Tax Cash Flow CF₀ = Total initial after-tax cash outlay (what you actually
(CF₀) pay)
C F 0=C 0 + ΔNW C 0+ OC C₀ = Capital cost: ALL costs to make the asset operational
(purchase price + installation + modification costs, etc.)
→ These are depreciable; CCA is claimed on this
amount.
, COMM 309 | Chapter 14: Cash Flow Estimation and Capital Budgeting Decisions | Page 3
ΔNWC₀ = Change in net working capital at time 0
→ Increase in inventory/AR = cash outflow (negative for
firm)
→ Increase in AP = cash inflow (positive for firm)
→ Working capital = Current Assets − Current Liabilities
OC = Opportunity costs (market value of resources already
owned
that will be used in the project)
Note: ΔNWC and OC cannot be depreciated for tax
purposes.
What Is Included in C₀?
The capital cost C₀ includes all costs that are necessary to make the asset operational and that
generate future economic benefits — these must be capitalized and depreciated (via CCA). Items that
generate no future benefits can be expensed immediately (full tax deduction in year 0). The Canada
Revenue Agency (CRA) mandates this distinction.
• C₀ includes: Purchase price + shipping costs + installation costs + modification costs to adapt the
asset for use.
• C₀ does NOT include: R&D already expensed, costs from previous periods (sunk costs), or
general overhead allocations.
Example 14-1 | Calculating CF₀
Given: Brennan Co. is acquiring a milling machine.
Machine base price: $625,000
Modification costs (to adapt for firm's use): $25,000
Additional raw materials inventory required: $100,000
Opportunity costs: $0
C₀ = $625,000 + $25,000 = $650,000 (entire amount is depreciable — both purchase and mods generate
future benefits)
CF₀ = C₀ + ΔNWC₀ + OC = $650,000 + $100,000 + $0 = $750,000
Note: The $100,000 working capital is a cash outflow but NOT depreciable. It will be recovered at the
end of the project.
The firm's actual cash outlay is $750,000, even though CCA will only be claimed on $650,000.
Expected Annual After-Tax Cash Flows (CFt)
The expected annual after-tax cash flows (CFt) represent the operating cash flows generated by the
project in each period t. These comprise two components: (1) the after-tax operating income generated
by the project (revenues minus operating costs, taxed), and (2) the CCA tax savings from the
depreciation deductions allowed by CRA.
COMM 309 — Business Finance
CHAPTER 14: Cash Flow Estimation and Capital Budgeting
Decisions
Comprehensive Exam Preparation Notes
14.1 GENERAL GUIDELINES FOR CAPITAL EXPENDITURE ANALYSIS
Chapter 13 introduced the capital budgeting evaluation criteria (payback period, NPV, IRR, PI) and
assumed that cash flows were given. Chapter 14 focuses on how to actually estimate those cash flows
— the most critical and often most difficult part of capital budgeting in practice. All estimates draw on
the firm's financial statements (Chapters 3 and 4) and Canada's Capital Cost Allowance (CCA) system.
The following 12 guidelines govern how cash flows should be estimated for capital budgeting
decisions:
1. Estimate all cash flows on an AFTER-TAX basis. Capital budgeting uses the firm's after-tax
marginal cost of capital (WACC) as the discount rate. To ensure consistency (comparing like with
like), all cash flows must also be stated on an after-tax basis.
2. Use MARGINAL (INCREMENTAL) cash flows — only the changes in cash flows that result
directly from the investment decision. This includes the effect on existing operations. If a new
product cannibalizes existing sales (e.g., a new product that generates $100K/yr but reduces
existing product sales by $40K/yr), only the net incremental $60K/yr should be used.
3. Do NOT include interest or dividend payments in the cash flows. Financing costs (interest,
dividends) are already captured in the discount rate (WACC). Including them in cash flows as
well would double-count them. Finance is always about separating the investment decision from
the financing decision.
4. Adjust for changes in net working capital (NWC). Projects often require additional investment in
current assets (inventory, accounts receivable) that ties up cash. These represent cash outflows
at the start and cash inflows at the end. NWC changes net to zero over the project life, but their
present values do NOT net to zero.
5. Treat SUNK COSTS as irrelevant. Costs already spent cannot be recovered regardless of the
decision going forward. Never 'throw good money after bad' — only future cash flows matter.
6. Include OPPORTUNITY COSTS. The value of resources already owned that will be used in the
project must be included at their current market (opportunity) value. Example: Land purchased
for $150K is now worth $200K. If used for a new project, the $200K current market value is an
opportunity cost — not the $150K original cost (which is sunk). The opportunity cost IS the
relevant cost.
7. Determine the appropriate TIME HORIZON. Projects should run as long as they are
economically viable — abandonment decisions must be considered. Projects are terminated
when it is economical to do so, not when engineers say the equipment stops functioning.
8. Ignore intangible benefits that cannot be estimated. Intangible benefits are sometimes used to
justify poor projects. If spinoffs can be quantified, incorporate them; otherwise, ignore them.
9. Ignore EXTERNALITIES. Externalities are consequences that benefit or harm third parties
unrelated to the firm (e.g., pollution, regional employment effects). These are not the firm's
responsibility for financial analysis; they are the government's domain. However, they may
significantly affect the final investment decision.
, COMM 309 | Chapter 14: Cash Flow Estimation and Capital Budgeting Decisions | Page 2
10.Consider PROJECT INTERDEPENDENCIES. Projects may be contingent (require each other) or
mutually exclusive. Undertaking a project now may create future opportunities (real options) even
if the short-term NPV is negative.
11.Treat INFLATION CONSISTENTLY — the fundamental principle is to compare like with like.
Either: (a) use NOMINAL (actual) cash flows with NOMINAL discount rates; or (b) use REAL
(inflation-adjusted) cash flows with REAL discount rates. Never mix the two. In practice, the
nominal approach is preferred because CCA deductions are fixed in nominal dollars.
12.Undertake all SOCIALLY REQUIRED investments by law, even if they have negative NPVs.
Regulatory compliance is mandatory regardless of financial returns.
📌 The Three Most Commonly Confused Guidelines — Exam Focus
SUNK COSTS vs. OPPORTUNITY COSTS:
Sunk cost: Already spent, cannot be recovered → IGNORE. (e.g., $150K paid for land 5 years ago)
Opportunity cost: What you give up by using a resource elsewhere → INCLUDE at current market
value. (e.g., $200K current market value of that same land)
INTEREST PAYMENTS: NEVER include in cash flows. They are already in the discount rate (WACC).
Including them would double-count financing costs.
CANNIBALIZATION: When a new product reduces existing product sales, the lost cash flows from the
existing product are NEGATIVE incremental cash flows that MUST be deducted. Only the net
incremental cash flows should be evaluated.
WORKING CAPITAL: NWC changes sum to zero over the project life (invested at start, recovered at
end), but their PRESENT VALUES do NOT sum to zero because of the time value of money. The
recovery is worth less than the initial outlay.
14.2 ESTIMATING AND DISCOUNTING CASH FLOWS
Capital budgeting cash flows are organized into three categories, each estimated separately and then
combined to compute the project's NPV. The three categories are: (1) the initial after-tax cash flow
(CF₀), (2) the expected annual after-tax cash flows (CFt), and (3) the ending (or terminal) after-tax cash
flow (ECFn).
The Initial After-Tax Cash Flow (CF₀)
The initial after-tax cash flow (CF₀) is the total cash outlay required to get the project up and running at
time zero. It is NOT the same as the capital cost (C₀) of the investment — CF₀ is broader and includes
all cash items at initiation, even those that cannot be depreciated for tax purposes.
Eq. 14-1 | Initial After-Tax Cash Flow CF₀ = Total initial after-tax cash outlay (what you actually
(CF₀) pay)
C F 0=C 0 + ΔNW C 0+ OC C₀ = Capital cost: ALL costs to make the asset operational
(purchase price + installation + modification costs, etc.)
→ These are depreciable; CCA is claimed on this
amount.
, COMM 309 | Chapter 14: Cash Flow Estimation and Capital Budgeting Decisions | Page 3
ΔNWC₀ = Change in net working capital at time 0
→ Increase in inventory/AR = cash outflow (negative for
firm)
→ Increase in AP = cash inflow (positive for firm)
→ Working capital = Current Assets − Current Liabilities
OC = Opportunity costs (market value of resources already
owned
that will be used in the project)
Note: ΔNWC and OC cannot be depreciated for tax
purposes.
What Is Included in C₀?
The capital cost C₀ includes all costs that are necessary to make the asset operational and that
generate future economic benefits — these must be capitalized and depreciated (via CCA). Items that
generate no future benefits can be expensed immediately (full tax deduction in year 0). The Canada
Revenue Agency (CRA) mandates this distinction.
• C₀ includes: Purchase price + shipping costs + installation costs + modification costs to adapt the
asset for use.
• C₀ does NOT include: R&D already expensed, costs from previous periods (sunk costs), or
general overhead allocations.
Example 14-1 | Calculating CF₀
Given: Brennan Co. is acquiring a milling machine.
Machine base price: $625,000
Modification costs (to adapt for firm's use): $25,000
Additional raw materials inventory required: $100,000
Opportunity costs: $0
C₀ = $625,000 + $25,000 = $650,000 (entire amount is depreciable — both purchase and mods generate
future benefits)
CF₀ = C₀ + ΔNWC₀ + OC = $650,000 + $100,000 + $0 = $750,000
Note: The $100,000 working capital is a cash outflow but NOT depreciable. It will be recovered at the
end of the project.
The firm's actual cash outlay is $750,000, even though CCA will only be claimed on $650,000.
Expected Annual After-Tax Cash Flows (CFt)
The expected annual after-tax cash flows (CFt) represent the operating cash flows generated by the
project in each period t. These comprise two components: (1) the after-tax operating income generated
by the project (revenues minus operating costs, taxed), and (2) the CCA tax savings from the
depreciation deductions allowed by CRA.
