[T1W2] - Project Appraisal
INCREMENTAL CASH FLOWS
Cash Flow Diagram:
Incremental cash flows are the difference in the firm’s expected future cash flows between two mutually-
exclusive scenarios
Incremental cash flow =“ project goes ahead ”−“ project does not go ahead ”
To include in calculating incremental cash flows:
● Opportunity costs - cost of fixed assets (lands, buildings, machinery) purchased to undertake
project, market value of fixed assets that could be put to alternative use
● Changes in Working Capital (WC) - WC is capital (cash, inventory) needed to run the project
● Taxes - Cash flow savings from capital allowances on buildings and equipment, opportunity cost
of capital is reduced because interest payments on debt are corporation-tax deductible
To NOT include:
● “Sunk Cost” - Cost already incurred and not recoverable
● Accounting allocations - Depreciations, accruals or other accounting devices
● Cash flows associated with financing capital investment - Interest payments, Dividends paid
CAPITAL ALLOWANCES, TAXES AND INFLATION
Capital Allowances
Capital allowances are akin to tax-deductible expenses and are available in respect to capital expenditure
from the purchase NCA bought for business operations.
● Capital allowances lead to lower tax bills and therefore increased after-tax cash flows
● They can be calculated via reducing-balance method (% Capital Allowance x WDV of asset) or
straight-line method
Taxes
Taxes are deducted from pre-tax cash flows to achieve after-tax cash flows. To obtain after-tax NPV,
after-tax cost of capital is used to discount expected incremental cash flows
Taxable Income=Pre −tax Cash Flow−Capital Allowances
Amount of Corporate Tax=Taxable Income x Corporate Tax Rate
In the UK corporate tax rate is 19%
INCREMENTAL CASH FLOWS
Cash Flow Diagram:
Incremental cash flows are the difference in the firm’s expected future cash flows between two mutually-
exclusive scenarios
Incremental cash flow =“ project goes ahead ”−“ project does not go ahead ”
To include in calculating incremental cash flows:
● Opportunity costs - cost of fixed assets (lands, buildings, machinery) purchased to undertake
project, market value of fixed assets that could be put to alternative use
● Changes in Working Capital (WC) - WC is capital (cash, inventory) needed to run the project
● Taxes - Cash flow savings from capital allowances on buildings and equipment, opportunity cost
of capital is reduced because interest payments on debt are corporation-tax deductible
To NOT include:
● “Sunk Cost” - Cost already incurred and not recoverable
● Accounting allocations - Depreciations, accruals or other accounting devices
● Cash flows associated with financing capital investment - Interest payments, Dividends paid
CAPITAL ALLOWANCES, TAXES AND INFLATION
Capital Allowances
Capital allowances are akin to tax-deductible expenses and are available in respect to capital expenditure
from the purchase NCA bought for business operations.
● Capital allowances lead to lower tax bills and therefore increased after-tax cash flows
● They can be calculated via reducing-balance method (% Capital Allowance x WDV of asset) or
straight-line method
Taxes
Taxes are deducted from pre-tax cash flows to achieve after-tax cash flows. To obtain after-tax NPV,
after-tax cost of capital is used to discount expected incremental cash flows
Taxable Income=Pre −tax Cash Flow−Capital Allowances
Amount of Corporate Tax=Taxable Income x Corporate Tax Rate
In the UK corporate tax rate is 19%
